Compiled by Khushi Tekwani
The Financial structure is the fundamental method through which a business finances its assets and operations. It is the mix of debt and equity that includes short-term liabilities, short-term debt, long-term debt and owners’ equity. Additionally, there is a common misperception that financial structure and capital structure are the same. Both are distinct, as the capital structure consists solely of long-term debt and equity.
It is not obligatory for a corporation to select a particular type of structure, so each firm is free to select the structure that’s best suited for them, be it a public or private firm. However, if a corporation wants to maximize its worth and wealth of equity for shareholders, it must create an ideal structure and not settle for a random combination of debt and equity. Because the structure chosen impacts the WACC (weighted average cost of capital), which has a direct consequence on the firm’s worth.
A significant reliance on debt funding allows shareholders to achieve a higher return on investment since there is less equity in the business. However, this financial structure is risky due to the company’s substantial debt obligations. A company positioned as an oligopoly or monopoly is best suited to support such a leveraged financial structure, as its sales, profits, and cash flows can be accurately predicted. An Oligopoly situation occurs when companies within the same industry collude, either explicitly or implicitly, to restrict output or fix prices, in order to achieve above normal market returns. Monopoly occurs when a single company or group owns all or nearly all of the market for a given type of product or service.
In contrast, a corporation operating in a highly competitive industry cannot afford a high degree of leverage since its earnings and cash flows are variable, which could result in missed debt payments and a subsequent bankruptcy filing.
The various factors which influence the decision of financial structure are:
1. Interest Coverage Ratio (ICR): It refers to the number of times companies’ earnings before interest and taxes (EBIT) cover the interest payment obligation.
2. Debt Service Coverage Ratio (DSCR): It is one step ahead of ICR, i.e. ICR covers the obligation to pay back interest on debt but DSCR takes care of the return of interest as well as principal repayment.
3. Cash Flow Position: If a company is confident that it will generate sufficient cash flow, it will employ a greater proportion of debt securities in its financial structure. Conversely, if there is a shortage of cash, it will employ a greater proportion of equity because it is not obligated to pay its equity shareholders.
4. Tax Rate: A high tax rate reduces the cost of debt since interest paid to debt security holders is deducted from income prior to tax calculation, whereas corporations must pay tax on dividends paid to shareholders. Therefore, a high marginal tax rate necessitates a preference for debt, whereas a low marginal tax rate allows for a preference for equity in capital structure.
In addition, the financial structure is influenced by variables such as return on investment, cost of equity, flexibility, stock market conditions, firm size, etc. How a company decides to raise capital is totally up to its finance managers or whoever is in charge of making those decisions; as a result, every firm’s financial structure is unique, but the decision is based on the same set of variables. Both internal and external influences influence the proportion of debt and equity funds in a corporation. Therefore, firms must consider all relevant factors when determining the proportion of debt to equity instruments in their financial structure.