Question

Prepare a memo to the partners of Packitup Partnership describing the concept of solvency, the two main components of corporate capital, and how capital structure decisions affect the risk profile of a firm.

Answer 1

Solvency is the ability of a company to meet its long-term debts and financial obligations. Solvency is essential to staying in business as it demonstrates a company’s ability to continue operations into the foreseeable future. While a company also needs liquidity to thrive and pay off its short-term obligations, such short-term liquidity should not be confused with solvency. A company that is insolvent will often enter bankruptcy.
Corporate capital includes any assets a company may use to finance its operations, and it may be derived through debt or equity sources.
Capital structure is the particular mix of debt and equity that make up a company's corporate capital.
How a company manages its corporate capital can reveal a lot about the quality of its management, financial health, and operational efficieefficiency.
Debt Benefits
Borrowed money has definite advantages as a source of capital. Interest on business debt is tax deductible, which lowers the cost of raising funds. Your lenders receive a fixed rate of return, so if a small business takes off, owners don't have to share the extra profits. Unlike equity investors, creditors don't get a vote in how you run your business, so you retain more control. These features make debt more attractive than equity -- unless you're at risk for defaulting on your debt.

Risk Considerations
If you operate in a speculative industry or business risk has increased, what otherwise would be a safe amount of debt becomes more dangerous. The level of business risk is shaped not only by your decisions but by what's happening to your industry, the economy, your ability to borrow more money and government regulation and social trends. In some situations -- for instance, your company is facing new competitors or new technology is shrinking your industry -- the risk may be high enough that equity financing is safer than debt.