Capital Structure

You Need to Know How Capital Structure Affect Your Profit

“Don’t spend Capital competing with people who are spending Profits.” Moffat Machingura

The source of money you invest is very important. Do you do your business with own money or borrowed money?  Well, when you started the business, whatever source the money came from was welcome. But this has an impact on your business.

The capital structure simply means the sources of money a company uses to fund its operations and proportionate of these sources.

Capital can be raised either through the availing loan or through equity. Equity finance comes from the owners’ capital. The loan can come from banks, NBFCs, or personal loans.

Equity money can be in the form of own money, friends, and relatives who invest in the company, for larger companies venture capital and private equity money and for very large companies; public also become shareholders through an IPO. They all are known as company owners in the proportion of their shareholding.

Suppose you need Rs. 1000/- to start a business. You bring your own Rs. 400/- and borrowed Rs. 600/- from the bank.

Your business earned a profit of Rs. 200/- for the year. You paid the lenders’ interest of Rs. 90/- and the balance Rs. 110/- remained with you.

How the capital structure would matter:

Owners Capital 200 400 500 600 800
Loan 800 600 500 400 200
Total Capital 1000 1000 1000 1000 1000
Profit before Interest 200 200 200 200 200
Interest for Lender @ 15% 120 90 75 60 30
Profit for Owners 80 110 125 140 170

Total capital and profit both are same but the money owners would take home differs based on the capital structure he chooses.

The capital structure becomes important as the company becomes bigger. Smaller companies have no choice. They have limited owners’ money and they can borrow the rest of the money based on the borrowing capacity. But when a company has a choice to raise debt i.e. loan or equity the issue of the capital structure becomes relevant.

Every form of the capital comes with certain attributes.

Loan/Debt: Fixed interest payment periodically and fixed repayment obligations. They need some security.

Equity: Neither fixed interest payment periodically and nor fixed repayment obligations. They don’t need any security. But they share profit.

Keeping these attributes of both forms of money, entrepreneurs have to decide which source and in what proportion would be an ideal capital structure.

The following table explains how higher % of profit and higher margin benefits the owners. They can earn more money with the same capital as the cost of borrowing is not dependent on the profit margin. It remained the same.

Owners Capital 200 400 500 600 800
Loan 800 600 500 400 200
Total Capital 1000 1000 1000 1000 1000
Profit before Interest 400 400 400 400 400
Interest for Lender @ 15% 120 90 75 60 30
Profit for Owners 280 310 325 340 370

In this case, higher profit did not change the interest cost. Had they taken capital from any other source as equity, and borrowed less, they would have to share the profit with them.

Owners Capital 200 400 500 600 800
Others Capital 400 200 300 200 100
Loan 400 400 200 200 100
Total Capital 1000 1000 1000 1000 1000
Profit before Interest 400 400 400 400 400
Interest for Lender @ 15% 60 60 30 30 15
Business Profit 340 340 370 370 385
Profit for Others 226.67 113.33 138.75 92.50 42.78
Investment % 66.67% 33.33% 37.50% 25.00% 11.11%
Profit for Owners 113.33 226.67 231.25 277.50 342.22
Investment % 33.33% 66.67% 62.50% 75.00% 88.89%

Same owners’ capital but a change in additional capital source affected owners’ profit. They took partial equity from relatives and partial loan.   Owners profit has reduced in all the scenarios.

The above examples explain how the source of money i.e. capital structure. affect the profit for the owners.

The dilemma and decision point are when to have more equity and let the equity investors take the share in the profit and when to have more debt and keep the profit for the self.

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Here are the factors which influence this decision: (if you have an option to choose these factors may be useful. If you don’t have any option, go for the money available for the business of course after knowing the pros and cons)

  1. Risky Business

In risky and cash erratic business debt could be a risky option. Inability to service the debt could put the business of the entire group in danger. An equity option is better in such cases.

  1. Capital Intensive Business

Telecom or Airlines, or Infrastructure these kinds of business requires huge capital. Even banks and Financial Institutions relax their lending norms to accommodate higher debt to equity ratio.

Usually, these kinds of companies depend largely on debt.  Here there is no choice of the owners but the compulsion of the business which determines the capital structure.

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  1. Steady Business

In a steady business, debt servicing is easy. In this kind of business profit margin and cash flow is reasonably assumed.  Owners can maximise their profit with more debt. The only thing to keep in mind is the cost of the debt and reasonable debt to equity mix.

Steady Business

Periodic evaluation of the structure is also necessary to avoid future shock.

  1. High Margin Business

In such cases also high debt can be serviced easily and the cost of capital can be affordable. We know how real estate business borrows heavily and at a higher rate of interest.   They can afford it as the margin is high.

But the lop side is when the business cycle turns, high debt could be very risky.

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  1. Low Margin Business

Cost cutting is important for low margin business. High debt means high cost. Companies operating in such industry usually borrow less or use the borrowing judiciously.

If the percentage of return to the equity holders diminishes below the market rate of return due to the interest on the debt, it is prudent to keep the debt component minimum.

Equity investment from other sources makes it sure that there is no fixed interest burden and whatever remains has to be shared with the equity investors. Debt component adds a fixed cost to the cost structure.

  1. Cost of Capital

This is another critical aspect when entrepreneurs decide the capital structure. Equity though seems free but is the costliest source of capital.

Cost of Capital

We have seen in the example above equity partners share the profit which usually is higher than the loan interest percentage.

Owners have to decide to balance the debt and equity so as to keep the return on investment in business remains attractive and at the same time, the risk is adequately balanced.

Sometimes though equity is costliest, the owners have to go for it as it comes without any annual interest and periodic repayment conditions.

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  1. Existing Debt-Equity Ratio

If the existing debt-equity ratio is high, it makes the business risky. Rating agency and lenders would ask the business to bring in more equity for more debt and a better rating.

In such a scenario, there is no option but to bring in more equity.

In the reverse scenario, owners can raise more debt as adequate equity is already invested in the business.

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  1. Business Control

Equity investment means investors becomes a partner in the business. This consideration is an important factor when deciding equity or debt investment. Even if the debt is affecting the bottom-line, the risk of business control going away make the owners decide in favour of the debt.

  1. Business Interference

Like the 8 above equity investors comes with business interference. In India initially, business owners were worried to allow private equity investors to invest in the company. They didn’t want to offer board seat and therefore interference to the investors.

Gradually the mindset changed when they saw more value from the PE investors. But business interference is a key consideration when decking to go for more equity from the other investor group or debt.

  1. Timing

Borrow when the market is good not when you need the money. Borrow when the company is performing well.

“The wait is as much journey as the motion, because timing is pivotal.” Innocent Mwatsikesimbe

Entrepreneurs learned during the 2008 financial crisis. In times of financial crisis, borrowing becomes difficult. Equity remains the only option. In times of the poor company, performance loan becomes difficult, but equity investors can invest after due diligence.

It all depends on market conditions and company performance.

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In nutshell, this is what the capital structure is. This is a very important business decision as the company grows. Do not decide either way without considering the pros and cons. An imbalanced and unplanned capital structure can ruin your good business.

You can lose control of the company with more equity investors and a lower percentage of promoters holding. High debt can drown the company as we have seen recent debacle of Reliance AGAG Group Companies, Jet and Kingfisher Airlines and many other companies struggling with NPA.

“And make sure that the capital structure we have in place is the right capital structure. I think that’s the reason that we’ve been successful.” Henry Kravis

You may also like to read: 26 Sources of Capital – All You Need to Know

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