Determining Optimal Structure of Capital & Financial Leverage


Capital Structure Analysis

In addition to assessing a firm’s ability to meet its short-term obligàlion, it Is impOrtaflt to evaluate its ability to pay long-term debts as they mature. This requires comparmg the amount oflong-term obligations andthe company’s ability to generate cash in the long term. This ability is greatly affected by the amount of long-term debt the company has in relation to equity.

Capital structure is the mix of long-term debt, on which interest and principal payments must be made, and equity, in the form of common and preferred stock, which the firm uses to finance operations. The capital structure affects both the risk and returns of the firm and is directly related to leverage.

Financial leverage is the use of debt (fixed cost funds) to increase returns to owners (stoctholders). Debt that is too low may result in a company not being able to take full advantage of opportunities. Debt that is to? high may affect the company’s ability to weather difficult economic times and continue to pay its obligations as debt or mterest payments come due. There is no standard guideline or optimal leverage number; this varies by industry and firm.

Firms have a mix of debt and equity fmancing. Debtholders, including fmancial institutions and corporate bond investors, are often, but not always, promised a return based on the stated interest rate for the debt. There are costs associated with issuing debt and equity. (Debt is usually cheaper but will increase as the firm’s ratio of debt to equity increases). Most companies maintain a balance of debt and equity based on the cost of capital for each and the level of risk they wish to maintain. 

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