Question

discuss the impact of capital structure on liquidity and profitability?

Answer 1

A) WHAT IS CAPITAL STRUCTURE?

The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

Key Takeaways

• Capital structure is how a company funds its overall operations and growth.
• Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
• Equity consists of ownership rights in the company, without the need to pay back any investment.
• The Debt-to-Equity (D/E) ratio is useful in determining the riskiness of a company's borrowing practices.

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with this debt and equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm's growth.

B) CAPITAL STRUCTURE - PLANNING

Some companies do not plan their capital structure, and it develops as a result of the financial decisions taken by the financial manager without any formal planning. Those companies may prosper in the short-run, but ultimately face considerable difficulties in raising funds in the long run. As a result, they cannot economize the use of funds.

Therefore, it is being increasingly realized that a company should plan its capital structure to maximize the use of funds. The primary objective of every capital structure planning is to minimize the cost of capital and to maximize the share value. In other words, the optimum capital structure is obtained when the market value per share is maximum and minimizes the average cost of capital. The term optimum capital structure has been theoretical.

C) IMPACT OF PROFITABILITY

In this paper an attempt has been made so as to ascertain the impact of capital structure on the profitability of a firm. This study is focused on automobile industry and five companies are taken as sample. The reference period of the study is five years and is completely based on secondary data which has been collected through various sources. In order to achieve the objectives of the study, the researchers have employed the analysis of various ratios. The findings of the study have put forth that capital structure do have statistically significant impact on the profitability of firms.

Capital structure and its impact on profitability can be examined by interest as percentage of gross profit and total income. It is presented in Table 3.5. Interest as a percentage of gross profit, in the case of Financial Technologies Limited, in the first year is zero as it has no business operations, It stood at 0.07 per cent in 2002-03, and increased to 12.33 per cent during 2007-08.

Later it declined to 0.36 per cent in 2009-10 and increased to 7.13 per cent in 2010-201 1. The average of percentage of interest to gross profit stood at 2,59 per cent. Interest as a percentage of total income also shows fluctuating trend during the study period. It varies between 0.02 to 4.52 per cent during the study period with an average of 0.88. Therefore, Interest paid on debt capital does not show any impact on shareholders wealth.

Relationship between capital structure and profitability

On the other hand, the relationship between capital structure of the firms and their overall profitability has been debated thoroughly in the literature. In this case, a point of agreement is the fact that the firms shall adopt an optimal capital structure that can allow them to reduce the overall costs of capital while at the at the same time ensuring that their profits are maximized. One of the key theories in this case is that of Modigliani and Miller Propositions. In the year 1958, Modigliani and Miller proposed the M&M (I) proposition, under which they indicated that no relationship existed between the capital structure and profitability of the companies. In this case, a set of stringent assumptions, however, was undertaken. These assumptions included, absence of taxes, presence of a capital market without any friction, absence of the cost of bankruptcy, as well as the elimination of all the other real-world implications.

Hence, the capital structure can influence the overall profitability of the firms, as it determines the financial leverage which adds to the overall expenses of the companies. Further research based on the M&M (II) proposition indicated that in the presence of taxes the use of debt has the capacity to provide the companies with tax benefits. However, these tax benefits can be out shadowed by the costs of debt, which increase with the increase in the overall debt balances of the company. In such a case, the companies can confront financial distress, which is a situation when the organizations’ costs of debt or interest expense exceed the overall tax benefits. Hence, it has been established by research that increasing levels of debt in the capital structure have a negative impact on the overall profitability of the firms.

D) CAPITAL STRIJCTURE AND ITS IMPACT ON LIQUIDITY

One of the most important methods of financial analysis that is commonly Interest used by both the suppliers of capital and the management of a firm is the ratio Source: Compiled from the annual reports of sample companies. Numbers of ratios are calculated for a period of years and are used to measure the present performance of the firm and also to forecast the likely trend in future. Long-term capital suppliers and owners are primarily interested in profitability of the enterprise. The suppliers of short-term capital are more concerned with the Interest a8 a percentage of Total income Total Income Interest as a short-term liquid balances. A company may have tremendous potential in terms of profitability in the long run but it may languish due to inadequate liquidity. percentage of gross profit Company's short-term liquidity position can be measured by using select ratios.

Term, liquidity, refers to the debt paying capacity of the concern. It also means the ability of the firm to provide cash to meet the claims of suppliers of goods, services and capital. Liquidity ratios measureqthe ability of the firm to meet its current obligations. Liquidity of a company can be studied-in two ways, namely

1) Technical liquidity

2) Operational liquidity.

Technical liquidity assumes the liquidation concept of business. On the other hand, operational liquidity assumes the going concern concept of business. The presence of liquidity propels a business into success. Both excess and shortage of liquidity have a bearing on the interests of the firm. Excess liquidity reveals that the company is carrying higher current assets than what is required for production. This will lead to blocking-up of funds in current assets without any return. The problems due to shortage of liquidity or inadequate liquidity would be many. Production may have to be curtailed or stopped due to lack of necessary hds. The liability of the firm to pay off the debts injures the credit worthiness badly. Due to short liquidity, they may be unable to mobilize the required funds from outsiders. Insufficient funds also lead to a slow down in the pace of growth. Liquidity is influenced more by low profitability.

E) REASONS FOR LOW PROFITABILITY

It has been observed that the Software lndustry in South India during the study period do not have the problem of liquidity as they have enough internally generated funds. This is possible due to the high growth rate in gross profit and net profits and due to retaining back of profits for their future expansion programmes.

F) Relationship between liquidity and firm profitability

Liquidity has been observed to have an influential impact on the overall profitability levels of the organization. In this case, weak levels of liquidity pose threats to the overall liquidity as well as profitability of the firms, as it makes the firm instable and risky. Apart from that, the levels of liquidity within the organization also determines the attractiveness of the companies for the investors and creditors, as it is indicative of the ability of the organizations to pay off their short-term debt in a timely manner. Additionally, liquidity also determines the degree to which the organization can effectively run its operations, as low levels of liquidity can hamper the overall routine operations of the organizations, which in return influence.

In addition to that, the companies are also required to maintain effective levels of liquidity as it allows them to ensure that they have the working capital required to run the operations, which can aid them in successfully completing the day to day tasks required to generate revenues and profits. In this case, the company shall also ensure that it maintains optimal levels of liquidity, this is because if the company has excessive idle working capital, then it can cause opportunity costs in terms of income lost. On the other hand, the insufficient levels of working capital hinder the overall profitability of the form by causing interruptions and inefficiencies in the operational processes