How is capital structure determined in an organisation?

Determining the capital structure in an organisation involves deciding the mix of debt and equity financing that will best support the company’s operations, growth, and financial stability. Treasury and finance teams analyse various factors to find an optimal balance that minimises the cost of capital while maximising shareholder value. Here’s how the process generally works:

1. Assessing the Cost of Debt vs. Equity

Debt: Debt financing is typically less expensive than equity because interest payments are tax-deductible, reducing the effective cost of debt. However, too much debt increases financial risk and may lead to financial distress.

Equity: Equity is more expensive than debt because investors expect higher returns for taking on the additional risk. Equity financing also doesn’t offer tax benefits but avoids the fixed obligations associated with debt.

Strategy: Organisations seek a balance where the combined cost of debt and equity (the weighted average cost of capital, or WACC) is minimised.

2. Evaluating Business Risk

Consideration: The nature of the business influences capital structure. Companies with stable, predictable cash flows (e.g., utilities) can often handle more debt, while those with volatile earnings (e.g., tech start-ups) may rely more on equity to avoid insolvency risk.

Strategy: Treasury analyses the company’s cash flow stability and industry characteristics to determine how much debt it can safely service.

3. Targeting a Desired Leverage Ratio

Consideration: Organisations often set a target debt-to-equity ratio or leverage ratio based on industry standards, investor expectations, and credit rating considerations.

Strategy: The target ratio guides how much debt vs. equity the organisation should aim for. Companies monitor this ratio and adjust financing strategies to maintain it.

4. Impact on Credit Rating and Financial Flexibility

Consideration: Too much debt can negatively impact a company’s credit rating, increasing borrowing costs and limiting access to capital markets. A high credit rating, on the other hand, provides better access to low-cost financing.

Strategy: Treasury balances debt and equity to maintain a credit rating that offers financial flexibility without excessive interest costs.

5. Evaluating the Tax Environment

Consideration: Since interest on debt is tax-deductible, organisations in high-tax jurisdictions may be incentivised to take on more debt to benefit from the tax shield.

Strategy: The tax advantage of debt influences capital structure, especially for profitable companies that can use debt to reduce their tax burden.

6. Funding Needs and Growth Opportunities

Consideration: Companies with significant growth or expansion plans may need a more flexible capital structure to support new investments or acquisitions.

Strategy: Treasury might choose equity to fund high-growth projects that require large investments without adding debt service obligations, or use debt for predictable, steady projects.

7. Market Conditions and Interest Rates

Consideration: Economic conditions, interest rates, and investor sentiment influence the cost and availability of debt and equity. For example, when interest rates are low, debt financing becomes more attractive.

Strategy: Treasury monitors market conditions and may increase debt financing when rates are low or equity financing when the company’s stock price is strong.

8. Investor Expectations and Signalling

Consideration: Investors view capital structure changes as signals of management’s confidence. For example, issuing debt might signal confidence in stable cash flows, while issuing equity could signal caution.

Strategy: Treasury considers investor perception when determining capital structure, as changes can impact stock price and investor relations.

9. Covenant and Regulatory Requirements

Consideration: Debt often comes with covenants—restrictions on certain activities to protect creditors. These covenants can limit operational flexibility, so organisations consider them when deciding on debt levels.

Strategy: Treasury evaluates the flexibility allowed by different financing options, as covenants might restrict the company’s ability to pursue certain strategies or increase leverage.

10. Financial Flexibility and Risk Appetite

Consideration: Organisations determine capital structure based on their risk tolerance and need for financial flexibility. Conservative companies may opt for more equity, while companies comfortable with risk may use more debt to leverage returns.

Strategy: Treasury aligns capital structure with the company’s risk management approach, ensuring adequate cash reserves and avoiding excessive leverage.

11. Retained Earnings as Part of Capital Structure

Consideration: Companies with substantial retained earnings might use these funds rather than raising external debt or equity, effectively “self-funding” their growth.

Strategy: Retained earnings offer an internal source of capital that doesn’t dilute ownership or add debt obligations, making it a preferred option if available.

Summary

An organisation’s capital structure is determined by carefully balancing debt and equity to minimise financing costs, support growth, and align with business risks. Treasury and finance teams use factors such as business risk, market conditions, tax advantages, investor expectations, and financial flexibility to create a capital structure that promotes stability and long-term value creation.