Question

What is meant by the terms capital structure? What are the elements of an organization’s capital structure? Briefly describe each of the elements. How do each affect the capital structure of the organization and value of the organization through the capital structure?

Answer 1

The capital structure is the debt-equity ratio of the company which defines that how much of the debt that company borrowed as per their equity in hand and the debt involves the debentures, long-term loans and other borrowings and equity is consist of the equity shares and preferred shares and it shows the proportion of the debt and equity.

The Elements of an organization's capital structure are as follows:

1.) Shareholder's fund - These are the owner's funds which creates capital by issue of the new shares and another option is to utilize the retained earnings to meet company's financial obligation. The shareholders funds play vital role in expanding the capital of the business but the shareholders are increased by the issuing of the new shares as a result there is increase in the number of the holders of shares and the company at the time of declaring dividend have to share their profits among the large number of the shareholder's and as a result they may need to use retained earning reserves for sharing equal profits and this affects the capital structure of the company as well.

2.) Preference capital - These are also known as the owners of the company and also enjoy the dividends from the profits but at fixed rate and they also enjoy their preferential rights to obtain the amount as a return on the company's capital in case of the company's liquidation prior to the equity shareholders and the preference share capital also may impact the capital structure of the company because it is a part of capital of company is paying dividends to their holders at the fixed rates.

3.) Retained Earnings - These are the company's reserve which are created out of the profits of the company and the company deducts the some part of their net earnings and put some money in the account as a general reserves so that they can use this amount in the contingencies or the development in the company's growth and they can also use this money to expand their capital to issue new shares and this may create impact to the capital structure of the company due to their reserves are flowing out and the company's capital is getting low and they need to increase their capital by adding more funds into the capital structure.

4.) Long term borrowings - This the one of the common sources which the company opt to take to meet their capital requirements and adding funds to their capital this is the means of the capital and the funds are used to expand the capital of the business and this the major part of the capital structure of the company, if the borrowing increases the debt to equity ratio also increases which shows that that company is in the high risk because they are increasing their long term liability through the the borrowings and they have less capital as equity in hand as compare to the debt.