Answer: Capital Structure and its components.
Capital Structure constitutes two words i.e. Capital and Structure. The word ‘Capital’ refers to the investment of funds in business while ‘Structure’ means arrangement of different components in proper proportion. A company can raise its capital from different sources i.e. owned capital, borrowed capital or both. To decide capital structure means to decide upon the ratio of owned capital (i.e. equity share capital, preference share capital, reserves & surplus) to borrowed capital (i.e. debentures, loans, etc).
According to John H. Hampton, “A firm’s capital structure is the relation between the debt and equity securities that makes up the firm’s financing of its assets.”
According to R. H. Wessel, capital structure is “the long term sources of funds employed in a business enterprise”.
According to Weston and Bringham, “capital structure is the permanent financing of firm represented by long term debt, preferred stock and net worth”.
The term capital structure means ‘financing mix’. It refers to the proportion of different securities raised by a firm for long term finance.
Components of Capital Structure:
The components of Capital Structure are as follows:
Equity Share Capital,Preference Share Capital, Retained Earning , Borrowed Capital.
I. Equity Share Capital:
Equity share capital is provided by equity shareholders and it is the basic source of financing activities of business. The holders of such shares bear ultimate risk associated with the ownership. Equity shares carry dividend at a fluctuating rate, depending upon the profits earned by the company.
II. Preference Share Capital:
Preference shares carry dividend at a fixed rate and enjoy preferential right over equity shares for return of capital in case of winding up of the company. Unlike equity shareholders, preference shareholders have limited voting rights.
III. Retained Earnings:
The part of the profit retained by the company for meeting future financial needs and for expansion of the firm is known as retained earnings. In simple words, it is ploughing back of profits.
IV. Borrowed Capital:
It consists of the following:
A debenture is a certificate of loan evidencing the fact that the company is liable to pay a specified amount with interest at an agreed rate.
B. Term Loans:
Term loans are provided by banks and other financial institutions at a fixed rate of interest. For e.g.
Capital Structure = Equity shares + Preference share + Reserves + Debentures
= 50,000 + 1,00,000 + 20,000 + 1,00,000