What Is Optimal Capital Structure And How Debt Effects It

What Is Capital Structure
 
When you are asking about what the optimal capital structure is and what it relates to what you will find is that it is regarding the debt and equity within a business environment.  It is the perfect amount of debt and the perfect amount of equity that mixes together to give the amount of return on investment and shareholder’s pocketbooks while at the same time having the minimum amount of cost.
 
When looking at the financial management of a company you will find that to be effective a company should have effective leverage.  In this article regarding financial management you will find some specific information regarding optimal capital structure and what the effects of debt are on the capital structure you have attained. 
 
Types Of Leverage Within A Company
 
When working on capital structure you will find that there are many different types of leverage.  The first type that needs mentioned is financial leverage. This is the ratio of the EBIT/EBT earning before the interest and the taxes compared to the earnings. The financial leverage is created when the company/business is relying solely on the funds they have borrowed for the financial operations of the company. Any change in the amount of operating income can have changes in different parts of the financial aspect of a company. A large percentage change when speaking about the firm’s net income can cause changes in the earnings per share while a small change in the operating income can result in major changes in the reduction of net income.  It is best to have a long term financing plan in place that is permanent and will involve the perfect solution of debt and equity.
 
Operating Structure
 
The operating structure of the business can often be changed accordingly if needed.  This will include the fixed operating costs. Examples of these costs are any administrative overhead, contractual salaries of your employees, mortgage/lease payments or any other expense that you may be paying every month that does not change from month to month. As a business owner you will see the where you operating leverage comes into play when there is a change in the net sales that result in a change in the operating income earnings. 
 
Combined Leverage
 
The combined leverage is defined as the combination of the effects of a business risk combined with the financial risk of the business. When speaking of leverage relationships there is a direct correlation between the degrees of operating leverage, financial leverage and combined leverage. There are many different calculations that can be created within these different operating margins. 
 
Optimal Capital Structure
 
When working with the term of optimal capital structure you will find that this is the use of debt and equity appropriately used to help minimize the business’s cost of capital and maximized its price in the stock market.  If you are looking to run your business on a non-optimal capital structure you will find that the small amount of optimal debt and equity will probably lead to a higher financing cost and you may have your business rejected if you are looking to build on some capital budgeting projects. There will many different effects that you will see when you are working with different types of capital structures and you will see them when looking at the business’ income statement. 
 
The Effects Of Debt On The Capital Structure
 
When we are speaking of debt and the effects of it on the capital structure you will find that the top benefit is when the amount of debt is increased is that the interest expense will reduce the amount of taxable income.  For this reason, many automatically think that it is best to increase your debt level to the maximum amount.  However this is not the case and can have a large detrimental effect on your business.
 
When you increase your debt amount you will find that many things happen such as your interest expenses and the need for a larger amount of cash flow to cover those expenses. This will not only make you as a business operator nervous but it will also make your debtors nervous. They will think that you will not be able to cover your financial responsibilities. You will also be aware that your stockholders will become nervous. As a stockholder they want to see the stock price go up not down.  If you have increased expenses the stock price will start to go down.  In many cases the expenses become too much to bear and the company will go bankrupt. This will leave the stockholders empty handed. 
 
Conclusion
 
The world of finances can be a complicated area to explore.  It becomes even more complicated when you are looking at it from different aspects such as the capital structure. When in doubt and if you have questions it is always the smartest idea to consult with a financial professional. They will be able to help you through the tough questions and help to get you on the road to financial success.

Post a Comment