Originally Written: 28 Apr, 2022 | Last Updated: 1 Aug, 2023
At Advivo, we understand that every business needs capital, but not all businesses are the same and not all types and sources of capital will be available when you need them. Our goal is to help you achieve your financial objectives, and part of that includes your understanding of capital, before creating a capital structure for your business.
Capital is the most important part of a business, as it is the foundation of a company. Debt and Equity are the two main types of capital sources for a business and there are many variations and hybrid types of debt and equity. Where you source the capital (debt or equity) will have a significant effect on the cost and terms applicable to that capital. Your capital structure is the combination of debt and equity that is used by the company to finance business operations and growth.
Another way to look at capital structure is as a debt-to-equity ratio, which is useful when determining the riskiness of a company’s borrowing practices. The debt-to-equity ratio, as the name suggests, is calculated using the two main capital sources:
Equity capital (also known as shareholders’ equity or owners’ equity) represents the amount of money contributed by shareholders. There are many different classes of shares with different terms, conditions and entitlements attached to each. Shareholder agreements are common in private companies and can also place significant restrictions on dividends and the ability to sell shares.
Whilst shareholders generally (depending on the share class) have an entitlement to dividends on both revenue and capital, it is important to note that debt generally has a prior ranking on returns over equity and also has a prior ranking in the event of insolvency.
Debt capital represents the money borrowed by the business. There are many types of debt capital, all with different terms and conditions, however, the fundamental difference to equity is that the principal (the amount borrowed) must be repaid, whereas equity is not repayable.
Both types of capital structures have an entitlement to provide the investor with a return. Equity holders receive a proportionate share of the after-tax profits in the form of declared dividends, so there must be profits before shareholders are eligible for any return. In contrast, debt has a structured interest payment requirement regardless of profitability. This, therefore, makes it riskier for the business as both interest and principal need to be repaid regardless of the business’s ability to repay from profits.
Different types of debt have different terms and conditions which are generally documented in a loan agreement. Some loans are secured, therefore giving them a higher ranking in payment priority in the event of insolvency, as opposed to unsecured debts which then rank ahead of equity.
The key issue with debt is to fully understand the loan’s terms and conditions, particularly the requirements for repayment of principal and interest, to ensure they align with your projected cash flow after an allowance for contingencies and market fluctuations.
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The optimal capital structure of a business is that which best suits the business’s objectives and cash flow needs and ability to service, not necessarily the lowest cost mix of debt and equity.
Choosing the optimal capital structure is all about risk management and to do this you need a clear strategic plan supported by robust and well-researched long-term financial forecasts. Getting this right is essential to the ongoing viability and success of your business and to maximising your business’ market value.
Optimum capital structure varies across all businesses, and what might be optimal for one business may not be the case for another. To see what sort of considerations you need to make when capital structuring your business, read our article Capital Structuring – What You Need to Know
Some factors that determine capital structure are:
- Financial forecasting
- Trading conditions and terms
- Degree of control
- Flexibility of financial plans
- Choice of investors
- Capital market conditions
- Period of financing
- Cost of financing
- Loan conditions
- Economic conditions & inflation
- Stability of sales
- Size of a company
- Government policies
Advivo understands that every business needs capital, but all businesses are different and there’s no one size fits all solution. Ultimately, capital structure will determine the long-term sustainability of your business, so careful consideration and professional advice from trusted business advisors, such as the ones at Advivo, are needed to make the best decision for your business.