What is capital structure ? Mention few factors that influence capital structure. (2+6=8)
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CAPITAL STRUCTURE means the proportion of debts and equity used for financing the operations of business.
capital structure= DEBT/EQUITY
factors that influence the capital structure are as following:-
✓ cash flow position:-
the decision related to composition of capital structure also depends upon the ability of business to generate enough cash flow. the company is under legal obligation to pay a fixed rate of interest to debenture holders and and dividend to preference share holders.
before including the debts in capital structure company must analyse properly the liquidity of it's working capital.
✓ Return on investment :-
if return on investment is more than rate of interest then company must prefer debt inits capital structure whereas if return on investment is less than rate of interest to be paid on debt, then company should avoid debt and rely on equity .
✓ Interest coverage ratio (ICR)
it refers to number of time companies earning before interest and taxes cover the interest payment obligation.
ICR= EBIT/ interest
high ICR means companies can have more of borrowed fund whereas lower ICR means less borrowed fund securities.