Capital is the fund required to initiate the activities of any business. It is the foundation of business finance. The capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Financial Leverage
The proportion of debt in the overall capital of a firm is called Financial Leverage or Capital Gearing. When overall debt in the firm increases, cost of funds declines as debt is a cheaper source of funds.
When the proportion of debt in the total capital is high then the firm is called highly levered firm but when the proportion of debts in the total capital is less, then the firm will be called low levered
Factors Affecting Capital Structure
1] Cash Flow Position
A firm’s ability to pay expenses and loans determines debt capacity. Some firms operate in volatile financial environments affecting their ability to meet financial obligations. The company may raise funds by issuing debts if it has a fluent cash flow position, as they are to be paid back after some time.
2] Interest Coverage Ratio
Interest Coverage Ratio is the number of times earnings before interest and taxes of a company covers the interest obligation. High-Interest coverage ratio indicates that company can have more of borrowed funds.
Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.
2] Interest Coverage Ratio
Interest Coverage Ratio is the number of times earnings before interest and taxes of a company covers the interest obligation. High-Interest coverage ratio indicates that company can have more of borrowed funds.
Interest Coverage Ratio (ICR) = Earnings Before Interest and Tax (EBIT) / Interest.
3] Control
Public issues damage the reputation of the firm and make it vulnerable to takeovers. Debt generally does not cost dilution of control. To have control, the firm must issue debt. So there is a constant struggle over whether to give up control or pay more for capital.
4] Return on Investment
It will be beneficial for a firm to raise finance through borrowed funds if the return on investment is higher than the rate of interest on the debt. But if the return is uncertain and the company is not sure if it can cover the fixed cost of interest, they should opt for equity.
5] Floatation Cost
Flotation cost must be understood while selecting the sources of finance. Cost of the Public issue is more than the floatation cost of taking a loan The cost of issuing securities, brokers’ commission, underwriter’s fee, cost of prospectus etc is the flotation cost.
6] Flexibility
Issuing debenture and preference shares introduce flexibility. A good financial structure is flexible and sound enough to have scope for expansion or contraction of capitalization whenever the need arises.
7] Stock Market Conditions
Conditions of the stock market influence the determination of securities. During the depression, people do not like to take a risk and do not take interest in the equity shares. During the boom, investors are ready to take a risk and invest in equity shares.
8] Tax Rate
Interest on debt is allowed as a deduction; thus in case of the high tax rate, debts are preferred over equity but in case of low tax rate more preference is given to equity.
Importance of Business Finances
We now know the meaning of Business Finance, let us learn its importance. Business finance is an essential requirement for the establishment of any business. Money is actually the most important tool to bridge the gap between production and sales. Let us take a look at some of the important functions of business finances.
- We require business finances to meet certain contingencies and any unexpected problems that may arise
Financial Management
What do you think is the most important aspect of running an organization? Well, it is the money of course. To run any kind of successful company or business, the funds have to be very well managed. This efficient management and utilization of capital is what we call Financial Management. Let us study all about it.
The capital contributed by the businessman to establish the business isn’t adequate to meet the financial needs of the business. Consequently, the businessman needs to search for an option to generate funds. A research of the financial needs and options to fulfill those needs must be done with a specific end goal to arrive at effective financial management to maintain the business
Importance of Business Finances
We now know the meaning of Business Finance, let us learn its importance. Business finance is an essential requirement for the establishment of any business. Money is actually the most important tool to bridge the gap between production and sales. Let us take a look at some of the important functions of business finances
We require business finances to meet certain contingencies and any unexpected problems that may arise
A requirement to avail any business opportunities that may present themselves
Process of Financial Planning
- Preparation of sales conjecture.
- Decide the number of funds – fixed and working capital.
- Conclude the expected benefits and profile ts to decide the number of funds that can be provided through internal sources.
- This causes us to evaluate the requirement from external sources.