There are many interpretations of the term “capital”. Almost all of them are reduced to three areas: real, monetary and labor. For more details on what constitutes a capital structure in general and at an enterprise in particular, read on.
At the present stage, the term “capital structure” includes all types of equity and debt. In the first category must be present not only the money initially invested, but also the reserves accumulated in the future, trust funds. Debt capital consists of leasing, commodity credit, current liabilities. The composition of funding sources plays an important role in the formation of enterprise value.
There are four basic concepts of the term "capital":
- indifference of the structure;
- contradictions of interests.
They are based on alternative approaches to the possibility of optimization and the allocation of factors affecting capital.
It lies in the fact that the structure is created by taking into account the different cost of individual elements. On the example of enterprises, this means that the price of raising own funds is always higher than borrowed. This is due to different levels of risk. The yield on borrowed funds is deterministic: the interest rate is determined by the parties in a fixed amount. The profitability of personal funds is formed in market conditions according to the results of economic activity.
The capital structure of an enterprise attracted from the outside is secured in the form of third-party guarantees, collateral or mortgage. In case of bankruptcy of the organization, the legislation of the countries provides for the right to satisfy the claims of creditors (first of all). That is, the use of borrowed capital leads to a decrease in the weighted average price of enterprise resources and an increase in the market value of the organization. The application of these principles in practice encourages owners to maximize loans, reduce financial stability.
It is based on a number of contradictory conditions that determine the level of profitability and risk, which should be taken into account in a certain way in the process of structure optimization. Within the framework of this direction, the following provisions were highlighted:
- Debt service costs are deductible from the tax base. Therefore, the cost of borrowed capital is always lower, and the demand for it to a certain extent causes a decrease in its price.
- With the increase in the share of borrowed funds there is a possibility of bankruptcy of the organization. Bankers are forced to reduce the amount of loans or require the company to analyze the capital structure in order to optimize it.
- The cost of individual elements of sources of financing attracted from outside includes not only expenses on debt servicing, but also initial expenses.
From the above, we can conclude that the owners or managers choose the level of profitability and risk based on their “preferences”.
Concept of conflict of interest
Managers receive more complete information about the activities of the organization than the owners. If shareholders owned the same data, they could manage the funds more correctly. So the optimization of the capital structure would occur faster.
With favorable growth prospects, managers will try to satisfy the need for finance by attracting borrowed funds. Otherwise, capital from external sources will be used, for example, additional investments by shareholders.
Lenders want to exercise control over the use of funds. These costs are passed on to the owners. The higher the share of borrowed capital, the higher the level of costs, the weighted average cost of funds and the market price of the enterprise. This is the definition of capital structure.
They are based on the following conditions:
- optimal level of profitability and risk;
- minimization of the weighted average cost;
- maximizing the market price of the enterprise.
The priority of specific criteria by which the capital structure of an enterprise is formed is determined by the management independently. But there is no single approach.
Optimization of the capital structure is to find the ratio of personal and borrowed sources of formation of funds, which will ensure the achievement of a balance between profitability and risk, minimize the weighted average and the market value of the organization. Over time, this ratio changes, so periodic adjustment of values is required. The dynamics of the indicator depends on the lending rate, the level of taxation, transaction costs and other factors.
The capital structure of the organization
The main principle of formation of funding sources is to maximize the price of the organization and find the optimal level of financial leverage - the ability to influence profits by changing the volume of long-term liabilities. Its dynamics depends on the rate of growth of net profit to gross income. The higher it is, the less dependence between the concepts under consideration. The level of leverage increases with the growth of the share of borrowed capital. At the same time, the profitability of funding sources and the level of risk are increasing. This is the financial capital structure.
The optimal formation of capital structure is a complex process. It must also take into account the ability of the company to repay debts from the income received, the stability of cash flows and other factors. You should also take into account the sectoral, territorial features of the institution, goals and strategies, the planned growth rate. The existing working capital structure is also taken into account. The risks of alternative financing options are not always, the projected interest rates are more affordable than own funds.
This paradox also has an explanation: real conditions are far from ideal, which Modigliani and Miller laid down in their theory. There are no absolutely effective markets, individuals and legal entities have different access to credit resources, but there are transaction costs. Therefore, for owners at this stage, an optimal capital structure is of higher priority. Moreover, interest on loans can be attributed to the cost of production, that is, to exclude them from the tax base.
An increase in the share of borrowed funds within reasonable limits can reduce the price of attracted capital. The task of financial management is to find these limitations. To solve it, it is necessary to develop principles by which the structure of fixed capital will be assessed. Some rules have already been formed in the theory of Myers sequence:
- It is preferable to finance the company from its own resources.
- Organizations impose dividends.
- If the volume of own sources of financing is insufficient, the company should reduce the portfolio of assets.
- If you cannot do without external financing, it is better to start with the issuance of the safest securities, and then proceed to the shares.
Indeed, the capital structure of an enterprise is such that bonds are a more affordable source of financing than stocks. The issue of the company resorted to the purpose of expanding production with low credit risks.
Advantages and disadvantages
The capital structure of large corporations usually has a ratio of 70:30. The more equity, the higher financial independence. With the increase of borrowed capital, the probability of bankruptcy of the enterprise increases. This forces lenders to raise interest rates, offsetting new risks. At the same time, organizations with a large proportion of borrowed funds have their advantages. With the same amount of profit they have a higher profitability.
It is formed by the value of the property invested by the owner. Calculated as the difference between total assets and liabilities. Equity has the following advantages:
- Simplicity of attraction: the decision is made by the owners without the consent of other subjects.
- Higher ability to generate profits, since there is no need to pay loan interest.
- Ensures the sustainability of the organization, its solvency and reduces the risk of bankruptcy.
Disadvantages of equity:
- Limited scope and opportunity to expand activities.
- High price.
- Do not use the opportunity to increase profitability.
- The most important thing is an enterprise that does not use loans, has financial stability, but is limited in development rates.
The structure of equity capital consists of authorized, additional, reserve fund, retained earnings. Let us consider in more detail each of these elements.
The authorized capital is the funds (property) invested at the time of foundation of the organization. Depending on the form of ownership, it may be called a share (general partnership), share (cooperative), foundation (municipal enterprise). It determines the share of each participant in the management of the organization and guarantees the interests of creditors. The structure of fixed capital can be adjusted only after a change in the constituent documents as a result of:
- attracting funds from participants;
- directing profits to increase funds;
- receiving subsidies from state bodies;
- withdrawal of participants from the enterprise;
- bringing the size of capital to the value of net assets;
- withdrawal of part of the fund.
Additional capital is the income created as a result of:
- trading (excess of the share issue value over nominal);
- revaluation of non-current assets;
- exchange rate dynamics - the difference of the ruble assessment of the founder's contribution in foreign currency at the date of receipt of the amount and that specified in the documents;
- the amount of retained earnings;
- donated property;
- bills from the budget.
In fact, this means, formed as a result of changes in the market price of the property. They can not be directed to the needs of the organization. Growth occurs only on paper.
These are funds intended to cover losses in the absence of other possibilities for their reimbursement, payment of dividends and income to creditors in the case when there is not enough profit. The reserve fund is a guarantee of the smooth operation of the organization. Its value may not exceed the amount set by the owners and recorded in the documents. Even at the legislative level for joint-stock companies and enterprises with foreign investments a minimum amount of the fund and its annual replenishment is established (5% of net profit). Whether the structure of the working capital of organizations of other forms of ownership will include reserves, or not, the founders decide.
Equity structure also includes a provision for doubtful debts. It is created based on the inventory of receivables. The value is determined separately for each shipment, depending on the client's solvency. If by the end of the current year the amounts generated will not be used, then they are to be attached to the profit of the year.
Additionally, other trust funds may be created:
- to pay vacations, bonuses, salaries;
- equipment repair;
- production costs for seasonal work;
- warranty service;
- cover other costs.
Their size, structure and order of formation are also regulated by statutory and internal documents.
This is the difference between the income received by the organization and the payment of all amounts due, including taxes and other obligatory deductions. This profit is used for capitalization, reinvestment in production. Owners can withdraw assets in the amount of earnings. But if the owners find it expedient to abandon their current income in favor of future benefits, then they can leave them on the organization’s accounts. This is reinvestment. The property of the owners only increases as a result of an increase in their share in the capital of the organization, and the enterprise is given the opportunity to expand the scope of its activities.
The amount of equity is the most important indicator of the financial stability of an enterprise. Its level determines the investment attractiveness of the organization. Therefore, the problem of proper management of own funds becomes important in the activities of an economic entity.
In the development process, an organization has a need to raise new funds. Borrowed capital is formed through loans, leases, subsidies, etc. Sources of funds can be very different. There is no clear answer to the question about the ratio of equity and debt in the capital structure. American scientists believe that it is the founders who must first finance the organization, and resort to loans only as needed. The opposite opinion exists among Japanese bankers. Companies with a large share of borrowed funds are more attractive, respectively, the confidence of banks is higher.
As for Russian enterprises, the structure of their borrowed capital is dominated by short-term and long-term loans (with a maturity of more than 1 year). They are a full-fledged resource, which is invested in large-scale projects and pays off by the time of repayment. These include debt on the loan, issued bonds, returnable assistance. Such funds are used to finance durable property. Short-term liabilities are attracted to cover the need for current assets. They are usually repaid within a few months. These include current payables, contributions to the budget and funds, advances received, prepayment of orders, debts to suppliers, etc. In theory, the enterprise is not forbidden to finance a long-term project with short-term loans. But in practice, this leads to an increase in risk activities.
Debt capital can be divided into interest (for example, loans) and interest-free (debt to suppliers, etc.). So this concept is very broad. Loans allow you to quickly cover the shortage of funds, but at the same time indicate that the company is funded by liabilities. A large proportion of loans in the capital structure is characteristic of organizations with aggressive financing policies. The effectiveness of their use is the main task of management.
To ensure the activities of the organization need cash. At the first stages of operation, the authorized capital is used. But sooner or later the organization will need to attract funds from external sources. Joint-stock companies can put up their shares for sale and attract new members of the organization. Enterprises of other forms of ownership have to use loans and borrowings. Such funds are raised at a certain percentage for a predetermined period. Competent management of the capital structure is to find the optimal balance between equity and debt, in which the increase in profitability will not occur due to a strong increase in risk.