A capital structure helps is a mix of debt and equity that will help you finance your business operations and assets. To develop a capital structure for your company, you need to examine the debt-to-equity ratio by dividing the liabilities by the total equity.
A good capital structure will minimize the weighted average cost of capital and maximize the market value. You want a sustainable capital structure for your operations and business growth, which means that you aim to maintain a balance between equity and debt financing that supports long-term stability and minimizes financial risk. Different companies have different capital structures. For example, capital-intensive businesses utilize more debt, while labour-intensive businesses utilize more equity.
Some companies specialise in helping businesses with corporate finance and restructuring. SFM Corporate Services is one such company. SFM’s company formation strategies include the calculated selection of capital structures and the implementation of effective restructuring plans. In the article below we will provide an overview of capital structures and how they benefit your business.
Types of Capital Structure
Debt Capital
This refers to borrowed capital utilized in your business operations. It can take on different forms, such as long-term bonds or short-term financial paper. The former is typically safer, as it allows for an extended repayment period. While the interest must be repaid, the principal can be deferred until after the maturity period. Short-term commercial paper serves as a quick means to raise capital for your business within a short timeframe.
Equity is the total money that the business owners or shareholders own. It can be in retained business earnings (part of the profits separated to develop the business) or contributed capital (among the investors as the company’s ownership price or when the business is incorporated).
Another example of business financing is preference share capital, which offers a unique form of investment wherein preference shareholders possess preferential rights over ordinary shareholders. Preference share capital provides shareholders with certain rights and benefits. These may include a priority in receiving dividend payments and a higher ranking for capital repayment in the event of company liquidation compared to ordinary shareholders.
Optimal Capital Structure
When your business has a perfect balance between debt capital and equity capital, then you have the optimal capital structure. This will help your business to maximize the market value while minimizing the costs of capital to run the business.
The capital structure of your business will be contingent upon the industry in which it operates, aiming to attain sustainability. For instance, if your business operates in the banking or insurance sector, debt capital constitutes a significant component of your capital structure. However, a high debt ratio may prove unsustainable for a petroleum company.
Vendor Finance
Vendor finance involves the provision of supplies to your business on a long-term credit basis. Typically, the credit period extends for a duration of 60 to 90 days. This arrangement aids in minimizing the cost of financing for your business, as the credit meter begins counting from the end of the credit period. Moreover, the interest rate associated with vendor finance is usually lower than that of conventional debt capital provided to your business.
Policy Holder Float
This is a common form of business capital in the insurance industry. As people contribute money, the business holds that money as a float to run operations or increase growth. It may also be kept in an account and earn interest until the debt is repaid.
How an Optimal Capital Structure Benefits Your Business
It maximizes the company’s wealth, net worth, and market value based on current and future capital flows when discounted by the weighted average cost of capital (WACC). It will also enhance simplicity in the structure of your business to understand and run. A complicated capital structure can be unsustainable and could confuse shareholders and discourage potential investors.
By implementing an appropriate capital structure, you can effectively maintain control and ownership of your business. It is crucial that this structure remains flexible enough to provide you with a wider range of borrowing opportunities whenever the need arises, all while ensuring that you retain control and ownership. Let’s explore the advantages of the primary capital options available for your business:
Equity Financing
A well-designed capital structure for your business not only enhances flexibility in raising funds but also bolsters ownership and control. Equity financing, in particular, amplifies both the ownership stake and the level of control you have over your business. Additionally, equity financing offers the advantage of reducing risks since there are fewer debts to repay.
Equity financing contributes to diversifying your investment portfolio, thereby enhancing your business’s credibility within the investment network. Investors and shareholders participating in equity financing typically have a longer-term perspective and do not expect immediate returns. This injects more capital into the business and promotes its sustainability. In the unfortunate event of business failure, there is no obligation to repay the investment.
Overall, adopting equity financing as part of your capital structure can foster financial stability, credibility, and long-term growth prospects for your business.
Debt Financing
Founders maintain control and ownership of the business, unlike equity capital, which may result in a substantial loss of ownership for the founder. Debt financing provides the opportunity to retain and reinvest the profits generated by the business. As a small business owner, opting for debt financing grants you greater financial flexibility, and the repayment obligations are confined to the agreed-upon repayment period. In the long run, debt financing proves to be a more cost-effective option for your small business. Furthermore, debts or loans are tax-deductible, offering potential cost savings, and enabling you to make strategic decisions with the available funds.
Key Takeaways
As a business owner, making sound capital structure decisions is a critical responsibility that cannot be overlooked. Depending on your business’s industry, you can adopt various capital structures, such as debt or equity capital. Striking the right balance between debt and equity is vital to achieving an optimal capital structure.
A sustainable capital structure plays a pivotal role in enabling your business to leverage market value and enhance ownership and control rights. Avoiding common pitfalls, such as lacking a sustainable capital structure, is essential to ensure effectiveness in the market and prevent liquidity issues.
When launching your business, it is imperative to devise a well-thought-out capital structure plan that prioritizes options that enhance control and ownership. This way, you retain the decision-making authority over crucial aspects of your business.
By carefully considering and implementing a sustainable capital structure, you can position your business for long-term success, optimal market performance, and effective control and ownership.