A successful business needs to get all its structuring on point, of which capital structure is key to investors and shareholders. It is similar to financial structure but has it’s differences too.
What is capital structure?
Capital structure is the combination of debts and equity used to finance long term operations and growth of a business. Also known as Capitalization, the structure only includes long term components – long term debts and equities that are used to satisfy long term needs.
Short term debts are not part of it, making a significant departure from the financial structure.
Components of Capital Structure
Capital structure includes long term debts and capital through equity, preference shares and retained earnings.
Long term debt
Debt that extends to a period more than one year and contributes to the capital for buying long term assets. Long term debt is usually the major component of the capital structure. The higher the long term debenture, the better the leverage is for the business.
Equity Capital
Capital sourced from selling/owning part of the business from shareholders is equity capital. It is common for a company to onboard investors as shareholders. The higher the shareholder, the lesser the control and power for the founders.
Preference Share Capital
Preference shares are like regular shares but they are given preference to take dividends up to a predetermined amount however less the profits are. The preferred shareholders are served their dividends before passing on to the shareholders.
Retained Earning
Earnings from the current year and previous that are not passed on as dividends and held back for further expenses of the company is also a working capital for the long run. The amount of earnings retained is decided by the board of directors based on the company’s future financial needs.
Capital Structure Vs Financial Structure
Both structures are the mix of debt and equity to fund the operations and assets of the company with the exception of capital structure leaving out short-term debts.
Financial structure of the company includes debts and shares, which is the entire left hand side of the company’s balance sheet. The capital structure only involves a portion of it making it a part of the financial structure.
Debt to equity ratio is the key metric of Capital Structure that helps understand cost of capital and profits per share. The higher the debt reliability, higher the company’s leverage will be. On the other hand, financial structure is used for more than leverage and gives a deeper picture of the business’s financial state.
Financial structure depends on internal components like debt, equity, operating capital and short-term and long term liabilities and external components like market and competitors. Further the design of financial structure involves legal structure, expansion plans etc. Capital structure is limited to long term funds alone.
Financial structure is a comprehensive financial statement used to understand and analyse the financial position of the company. capital structure is a part of financial structure and asset structure is the complementing pair to financial structure.
Asset structure vs capital structure
Asset structure is the mix of current, non-current assets, intangible assets, loan assets, warehouses, equipment etc owned by the business. It is the entire right side of the company’s balance sheet.
Asset structure doesn’t share much with the capital structure except they can be found in the same document – balance sheet. Capital structure is the structure of the funds available and assets structure is the reflection of the same in the form of assets.
Winding up
Capital, asset and financial structure are the three main pillars of financial structure that make up the finances of a business as a whole. The above approaches combined with tax optimisation can help improve the financial performance of the business to a greater extent.
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