Capital Structure: Developing a Broader Understanding

Systematic Scrutiny of Literature on Capital Structure 

Economic system randomly yields economic opportunities, which are exploited by companies. Companies, firms or organizations have developed various kinds of instruments and tools to exploit these economic and corporate opportunities. When we study contemporary firms, we learn that as the economic and corporate realities change, so do the capacity, instruments and tools. Internal resources, such as financial resources, are employed to increase the capacity, ability and efficiency of an organization.

Before we discuss different factors and elements, which directly or indirectly influence the ability of an organization to operate, it is imperative to discuss the very structure of modern corporate system. The contemporary economic/corporate system is a result of globalization of economies, which has given organizations, firms or companies access to new markets, which are more lucrative. There are two factors, which have given birth to global economy; the adoption of liberal economic model and advances in the realm of information and technology.

The liberal economic model is based on the idea that when international organizations enter market, it increases the efficiency of markets, reduces prices and increases consumer surplus. The increase in the consumer surplus directly impacts real income, which increases aggregate demand that acts for investors to invest more. Another advantage, of competition, is that it increases optimal use of resources, which facilitates economy’s objective of sustainable economic growth.

Other than liberal economic model, the globalization is facilitated by information and technology. Companies now can identify lucrative markets, based in data, and then penetrated these markets by devising strategy, which would be potent in particular economic conditions or systems.

In different studies, organization’s ability and efficiency to perform, is defined by its capacity to operate. It has been acknowledged that there are different factors and elements, which direct and indirectly influences the capacity and ability of an organization to perform efficiently. One of these factors or elements, is financial; element. In addition to financial element, it is the organizational structure that directly influences capacity and ability of an organization to generate revenue, by exploiting different economic opportunities, in different time lines.

Organizational and Capital Structure

For this research work, which focuses on the ability of an organization to perform or operate, it is essential to identify two different factors, which assists an organization to perform, as per standard. These two factors are Organizational and Capital structure. These two factors are relevant and valid, because 1) operations and efficiency of operations depend on these two factors. Studies, on organizational structure, has identified that it is structure, which is constituted by internal institutions of an organizations, which regulate explicit and implicit sub-systems or mechanisms to perform a task. In addition, organizational structure also directly influences the flow of information, among different departments and institutions, which impact efficiency.

However, before organizational structure, comes the capital structure, as it is the ability of an organization to finance its various kinds of operations? In pure economic terms, capital structure is defined as firm’s discretion of financing its corporate relation operations.

An organization requires financial resources to operate. For instance, to hire human resource, as employees, it requires funds. For the production, of a good or unit, it requires input, which it must buy from market. Therefore, for any sort of operation, financial resources are required. Though, it is also true that capital structure or capital structure requirements vary from industry to industry. This is because, in different industries, business operations are of different nature and profitability of industries also varies, which strongly influences capital structure.

Different Modes of Financing for a Firm

Firms can finance their operations through different means and these means establish their capital structure. The most basic form of financing is through the earned revenue. Organizations that operate in an industry whether manufacturing or not, produce different kinds of products and services, these products and services are then sold, usually, at higher price than the cost, which an organization has incurred in producing these products or services. Generally, these are revenues, which are accumulated or earned by selling of productions that are used for financing of profit and also for the expansion of corporate.

Another common source, of financing business operations or expansion, is debt. Generally, two different methods are used for debt; 1) one method includes banks 2) and other method includes debt issue. However, the cost, which is paid by the firms, for acquiring finance from private banks, is loan. Debt issue, which is used as an instrument or source of financing by large corporations, is actually the issuing of bonds with the promise to rerun in near or distant future.  However during this time, a corporation pays interests, during regular intervals on the debt. Some companies rely more 9on debt than any other source (Leon, 2013).

Debt, especially from the private banks, is also affected by exogenous factors, such as monetary policy of central bank. When monetary policy, of central bank, changes, it directly impacts demand for loans. For instance, when interest rates are high, demand for funds for corporate purposes, by firms of different sizes, drops dramatically. In a contrary situation, when central bank adopts an expansionary policy, the demand for funds for corporate purposes, by firms of different sizes, increases.

Equity financing is also a popular method, which is generally used by large firms, to finance their enterprise or business operations. This method involves selling part of an organization or firms, which provides organization the required funds for corporate operations. The apparent benefit, of this type of financial sourcing, of business, is that with equity, firm does not have pay any interest; however, the only drawback is that the size of profit reduces, after it is being shared with shareholders. These different methods or modes of financing are when used in particular ratio, capital structure of a firm is formed (Akeem, 2014).

Different Contemporary Understandings of Capital Structure

Modern financial experts and corporate veterans have defined and explained capital structure as the decision of a firm of mixing various financial resources, which are made up of both debt and equity. In another contemporary study, capital structure has been defined as how much debt a company or firm must have relative to its equity? To understand capital structure, corporate veterans assert that its financial sourcing must be identified. Therefore, the borrowing policy, of an organization, is a reflection of its capital structure. Most of the studies have concluded that capital-structure is debt-equity ratio. This capital structure and changes to it are discussed in study on Nigerian firms, in the context of financial performance and capital; structure (Adesina, Nwidobie, & Adesina, 2015).

Debt equity ratio has direct relation with profitability; therefore, there must be an optimal level of debt-equity ratio. The term optimal level of debt-equity ratio suggests it is such level of ratio, at which profitability is high. This suggests that when debt-equity ratio is at optimal level, a firm, company or organizations earns higher profit. This perception that there is optimal level of debt-equity ratio and it has direct correlation with profitability gave birth to several theories. The most common and popular of these theories are Trade-off, Peeking order and Agency theories. However, numerous studies have inferred that though an optimal level of equity-debt ratio exists; however, it has not been identified, as it varies from firm to firm. Therefore, the optimal level of capital structure is not yet discerned. However different optimal levels are being attained, by different firms, in different parts of the world, by altering debt-equity ratio (Adesina, Nwidobie, & Adesina, 2015).

As it has been established that there is direct link between profitability and optimal level capital structure; therefore, companies or organizations must have such capital structure that leads to more profitability. Therefore, all the decisions, regarding the capital structure of a firm, are sensitive decisions and they are taken with great caution. In addition, capital structure also has a peculiar relation with equity and debt. For instance, when an organization establishes itself as a profitable organization, the chances, of acquiring finance through equity/debt, increase. This is because an investor or shareholder will only be willing to buy shares of that company, which is profitable and would avoid investing money in those organizations, which are loss-making firms. Similarly, banks issue loans for not only lucrative enterprises, but also only to those firms, which are earning profit. This is because a firm, which is earning profit, is perceived as a firm that functioning optimally and using all its resources with caution and in an optimal manner (Addae, Nyarko-Baasi, & Hughes, 2013).

Capital Structure Decisions

Capital structure decisions are generally related to the debt-equity ratio. These decisions are sensitive and have great value attached to them because they directly influence the margin or size of profit. For instance, when a firm, company or organization decides to increase debt value/scale in the debt-equity ratio, it has to consider various factors. If an organization has acquired debt at high interest, this interest, which is a cost of loan, will ultimately be added to the price of product or service, which will influence sale and profit. For instance, in some economies and it industries, firms rely more on debt than equity (Leon, 2013).

When a loan is issued at higher rent (interest) the cost of producing a unit also increases, which reduces profit. However, when the rent of issued loan is low, it does not affect price much, which allows an organization to remain competitive in global system, where accessing markets is not difficult for organizations. Another way of look at this example is that when an organization earns revenue, after selling products or services, tangible or intangible, a portion of that revenue goes in form of interest to the financial institutions, from which funds have been burrowed. Higher the rent, on the burrowed capital, smaller is the size of profit that is earned after the deduction. Therefore, equity-debt ratio has great relevance and it is a serious and sensitive decision, which taken by organization. The data pertaining to the manufacturing firms in Nigeria suggests that there is negative relation between debt and leverage. In addition, higher the ratio of debt, more difficult it is for firms to realize their corporate objectives (UREMADU, 2012).

 Types of Debt

Generally, there are two kinds of bet; 1) short term and 2) long-term. Short-term loans are usually issued at higher interest rates; whereas the long term loans or capital is issued on lower interest rates. In different parts of the world, it is the corporate culture, which influences whether a firm would take a short-term loan or a long term loan.

When an economy is volatile, which suggests that economic growth fluctuates frequently, firms generally make short –term investment and therefore, they require short term loans for corporate operations, investment or business expansion. However, in stable economies, firms, companies or organizations are not shy from burrowing funds for a longer period (long-term loan) at lower interest rate.

In Ghana, which is a country in Africa, companies generally burrow short-term loans and pay higher interest rates. This has to do with the structure of Ghana’s economy, which has seen fluctuation since 2006, when the Great Recession started around the world (Mireku, Mensah, & Ogoe, 2014).

When we study Ghana firms in the context of debt equity ratio, we learn that more of these companies rely on debt for the financing of operations, rather than equity. When it comes to the numbers, we learn that debt, to the total capital ratio, is around 52% (short-term). However the debt to the total capital ratio is only 11% (long-term). These numbers are rare and provide understanding regarding how debt-equity ratio changes, when nature of the debt changes. For instance, for the Ghana listed firms, debt equity changes, when the nature of debt (not the interest rate), changes. This reveals that not only interest rates influence the debt-equity ratio, but also the nature of loan, long or short term, changes the debt-equity ratio (Addae, Nyarko-Baasi, & Hughes, 2013).

From the studies it also apparent that Capital Structure is being used as an instrument, by organizations, of different class, structure and size, to increase their earnings. Against the emphasis is on mix ratio, of debt and equity, which increases the profitability. In the early sections, of literature review, we have established that profitability has direct corporation with optimal capital structure, which in fact is debt-equity ratio. In Nigeria, banks have used various debt-equity rations to improve their earnings (Adesina, Nwidobie, & Adesina, 2015).

In some of the researches, planned capital structure decisions are purposed, rather than reactive capital structure decisions. This is because planned capital structure decisions are more effective and they are produce desires results, rather than reactive capital –structure decisions, which are based on previous decisions, pertaining to capital structure, of an organizations, It is also very apparent that capital structure is not just influenced by nature of debt and interest rate (CHISTI, ALI, & SANGMI, 2013).

For instance, the size of an organization directly influences its decisions of capital-structure. The study, conducted by European Central bank, inferred that organizations, firms or companies, which are classified as Small Medium Enterprises (SMEs) face challenges, when it comes to debt issuing. However, SMEs make 89% of total organizations, which operate in European Union. Therefore, these organizations, which have small or medium size are not facilitated by private banks and because of the challenges in burrowing funds from conventional means, such as private banks, are enormous, which push them to finance their operations through different sources. This directly impacts capital structure, as it influences debt-equity ratio (Europa, 2016). 

Some studies have used the accounting profitability, by Return on Equity (ROE) and Return on Assets (ROA) to understand the influence of capital structure on the profitability. As the financial performance in these studies have been measured by the accounting profit as organizations operate in corporate system for profit and this is how financial institutions understand performance, therefore, it becomes simple to understand how performance is directly and indirectly impacted by capital structure.

 One of these studies, in the context of Sri-Lanka, found out that there is negative relation between leverage and return on equity. The study infers that most of the companies, which operate in Sri-Lanka’s corporate system, rely on debt rather than equity, In fact that ratio, of debt in total debt-equity, is 73%, which is extremely high (Leon, 2013).

It has also been suggested that there are different factors, which influence the decision of burrowing funds, from various sources, rather than using equity as a source of financing (Leon, 2013).

How capital structure is important for a firm, different studies have different assertions. For instance, it has been asserted by firms that debts benefits companies in number of sways. As debt is non-taxable, it can used not only to finance business operations/expand business operations, but also to increase value of an organization. Generally, debt is issued to those companies or firms, which have been performing well. For financial institutions, performance is measure through profitability and higher the profitability, more these financial institutions issue loan. This also aids organizations in equity related matters, as the perception, of a firm or organization, is positive for potential shareholders, as financial institutions are trusting organization (Akeem, 2014).

Another benefit, of debt, is that it compels financial mangers to take better investment decisions. For instance, when surplus financial resources are used, there is a chance or managers have incentive to use them in less lucrative enterprises, which is a waste of financial resources. Therefore, debt keeps things in perspective and compels organizations to allocate their financial resources for more lucrative enterprises. However, this again comes down the organizational size, structure, monetary policy that prevails and corporate environment.

In addition, various studies, pertaining to developing countries, have suggested that burrowing is a serious challenge in developing countries, whether these developing countries are in Asia, Africa, or Europe. Therefore, the optimal level, of capital structure, is hard to attain in developing countries, as firms in these countries don’t acquire funds easily, which force them to use unconventional methods for financing. Thus, capitals structure, of firms, which are operating in developing countries, is different from the firms, which operate in developed countries (Iavorskyi, 2013).

Study, regarding the Nigerian manufacturing firms reveals that firms are striving to achieve optimal level of capital structure; however, for each firm, there is a different level of optimal capitals structure, as their size and profitability differs from other. This unique characteristic, of each organization, suggests that each and every firm has to find its own optimal level of capital structure. In addition, it has also been suggested that long-term loans should be part of equity-debt ratio, as long-term loans have greater benefits. For instance, under the simple and normal OLS functions, long term debt leads to greater profits. Therefore, in one of the studies, it has been suggested that Nigerian manufacturing companies must make long-term debt part of their capital structure, as it keeps them more operative, more sensitive regarding resource allocation and it would improve the capital and organizational structure of a firm (UREMADU, 2012).

In some corporate and economic systems, there is negative relation between capital structure and performance of organizations. Therefore, it has been suggested that the capital structure must have great share of equity than debt. The debt, which could be of two natures (long and short-term), is tied to interest rates and interest rates not only affect demand but also profitability. In systems where interest rates are high and profits are low, debt must be avoided and the emphasis should be on the equity (Akeem, 2014).

It is also imperative to understand that almost all studies suggest or conclude that performance, of an organization, is affected by its capital structure (CHISTI, ALI, & SANGMI, 2013). However, the study suggests that less the ratio of debt in capital structure, higher the performance, as it is established in the context of firms from Ghana (Mireku, Mensah, & Ogoe, 2014).

 For academic assistance: amanmushtaqpasha@gmail.com

References

Addae, A. A., Nyarko-Baasi, M., & Hughes, D. (2013). The Effects of Capital Structure on Profitability of Listed Firms in Ghana. European Journal of Business and Management , 215-230.

Adesina, J. B., Nwidobie, B. M., & Adesina, O. O. (2015). Capital Structure and Financial Performance in Nigeria. International Journal of Business and Social Research , 21-31.

Akeem, L. B. (2014). Effects of Capital Structure on Firm’s Performance: Empirical Study of Manufacturing Companies in Nigeria. Journal of Finance and Investment Analysis , 39-57.

CHISTI, K. A., ALI, K., & SANGMI, M.‐i.‐D. (2013). IMPACT OF CAPITAL STRUCTURE ON PROFITABILITY OF LISTED COMPANIES (EVIDENCE FROM INDIA). The USV Annals of Economics and Public Administration , 183-191.

Europa. (2016). Entrepreneurship and Small and medium-sized enterprises (SMEs). Retrieved April 30, 2017, from Europa: https://ec.europa.eu/growth/smes_en

Iavorskyi, M. (2013). THE IMPACT OF CAPITAL STRUCTURE ON FIRM PERFORMANCE: EVIDENCE FROM UKRAINE. Kyiv School of Economics , 1-43.

Leon, J. (2013). The impact of Capital Structure on Financial Performance of the listed manufacturing firms in Sri Lanka. Global Journal of Commerce and Managment Perspective , 56-62.

Mireku, K., Mensah, S., & Ogoe, E. (2014). The Relationship between Capital Structure Measures and Financial Performance: Evidence from Ghana   . International Journal of Business and Management , 151-160.

UREMADU, S. O. (2012). The Impact of Capital Structure and Liquidity on Corporate Returns in Nigeria: Evidence from Manufacturing Firms . International Journal of Academic Research in Accounting, Finance and Management Sciences , 1-16.