Capital structure is one of the important decisions taken by firms. Capital structure decision is taken under the financial management that is related to the financial pattern or the proportion of using the different sources in raising funds. The funds are categorized into two parts: the first is ownership-biased funds and the second is borrowed funds. Ownership funds is refers to the funds consisting of equity share capital, preference shares capital, reserves, and surplus-related funds. Borrowed funds are related to loans, debentures, public deposits, etc. mostly companies adopt the mixed capital structure for the fiancés of the company. But The decision on capital structure is depend on the relative proportion of various types of funds. Companies should be considered the amount of liquidity for payment of the interest rates and maintaining the outflow and inflow of cash in the business. If the companies are raising funds then they should pay the interest on the principal amount. In this case, the business needs a sufficient amount of cash to manage the outflow of business. Similarly, many important factors determine the choice of capital structure that is following.
Position of cash flow in the business
A certain amount of cash flow is required before borrowing. Cash flow is a must for maintaining the fixed cash payment obligation and management of the buffer also. it must be considered by the businesses that they have a sufficient amount of cash in the business for the operation of the business, investment in fixed assets, and for the completing the debts services commitment like paying interest on principle amount and the repayment of the principal amount. So the position of cash flow is very important before adopting any capital structure.
Interest coverage ratio
The interest coverage ratio refers to the number of times earnings before interest and taxes of companies that shows cover the interest obligations by the business. The method of calculation is.
Interest coverage ratio = EBIT/ interest
This shows the higher the ratio, the lower risk of the company of meeting its interest payment obligation. However, this ratio is not only sufficient for measuring because the firms may have a high-interest coverage ratio but a low cash balance. Apart from the interest, there are a lot of payment obligations also relevant.
Debts services coverage ratio
The debt services coverage ratio is linked with the interest coverage ratio. In this ratio, the businesses or firms compare the cash generated by firms and the requirement of cash of operating the business effectively. The operation of a business is related to debts and preference shares. It calculates as follows
Profits after tax + deprecation + interest + non cash exp. / preference share dividend + interest + repayment obligation.
Debts services coverage ratio shows the ability to meet the cash commitments; the company has the potential to increase dept components in its capital structure.
Returns on the investment ratio
If the return on the investment is high then the businesses or companies can choose to use the trading on equity for increasing funds. Returns on the investment ratio show the ability to raise funds from the equity and preference shares. It attracts people to invest more business for getting high returns.
Cost of debts
A cost of debt shows the ability to borrow at a low rate and increase its capacity. Businesses can raise funds from debts if the debts rise at a lower rate. The cost of debts affects the decision of capital structure because it impacts business by the high interest on principle impact the cash flow of business.
The interest on the debts is deductible expenses from the profits so the cost of debts is affected by the rate of interest. For example, the firm borrows at 10 percent interest and the tax rate is 30 percent, after deducting the tax the business cost of debts is only 7 percent. Thus this shows that higher tax rates cheap the debts relatively.
Cost of equity
The investment of equity is always depending on the returns of the company or business. If a business wants to raise the funds through equity then the returns of the business will affect investors. Stocks owners expect a rate of return from the equity against of risk they take or assume. If a company increased debt risk then it should increase the risk of shareholders also. Simultaneously, it increases the desire for returns also. It is for this reason that a company cannot able to take debts beyond a point.
There are several cost effects in process of raising resources that also involves some cost. There is a lot of expenditure incurred while the public issue shares and debenture. Getting a loan from a financial institution may also involve some costs. This is a considerable fact when choosing the capital structure.
This is also an important factor that affects the business for adopting any way of capital structure. We discussed above that if the business increase the debt risk then it will increase the financial risk also. Financial risk refers to a position when a company is not able to complete its fixed financial charges like interest payments, dividends, and any other payment obligation. Rather than financial risk business has some operational risk as well. If the business has a higher fixed operational risk then the higher business risk and vice-versa. The total risk of a business or company is depending on the financial risk and operational risk of the business. So business needs to consider risk factor before choosing any capital structure.