Capital Structure and Leverage

Capital Structure and Leverage

1. Capital Structure And Leverage

2. Capital Structure The capital structure is how a firm  finances its overall operations and growth by using different sources of funds . Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings.  Short-term debt such as working capital requirements is also considered to be part of the capital structure.

3. Capital structure planning Capital structure planning is very important to survive the  business in long run. After simple watching  the balance sheet of company, you see two sides of balance sheet. One side is liability side and other side is asset side. Liability side is the mixture of finance of company and it has been used or will be used for development of company.  Liability side of balance sheet is made under perfect capital structure planning

4. Capital structure planning  makes strong balance sheet. The right capital structure planning also increases the power of company to face the losses and changes in financial markets.

5. Optimal capital structure is a mix of debt and equity that seeks to lower the cost of capital and maximize the value of the firm . To calculate the optimal capital structure of a firm, analysts calculate the weighted average cost of capital (WACC) to determine the level of risk. Optimal Capital Structure

6. Leverage Leverage refers to the employment of assets or sources of fund bearing fixed payment to magnify EBIT or EPS respectively . So it may be associated with investment activities or financing activities.

7. Types of leverage  Operating Leverage   Financial Leverage Combined Leverage

8.  Operating Leverage Operating leverage is concerned with the investment activities of the firm. It relates to the incurrence of fixed operating costs in the firm’s income stream. The operating cost of a firm is classified into three types : Fixed cost Variable cost Semi-variable or semi-fixed cost

9. Fixed cost is a contractual cost and is a function of time. So it does not change with the change in sales. Variable costs vary directly with the sales revenue. If no sales are made variable costs will be nil. Semi-variable or semi-fixed costs vary partly with sales and remain partly fixed. Operating Leverage = % change in EBIT / % change in Sale

10. Financial leverage   Financial leverage is known as trading on equity . If any company's finance manager knows that company's return on investment is more than interest on loan, At this time , if company needs more money , then finance manager gets its loan and bought the asset from same loan. So , any technique in which any asset is purchased with loan and trying to increase EPS , then this is called financial leverage .

11. Financial leverage = % change in Earning per share / % change in earning before interest and tax 

12.   Combined leverage  It is the product of operating leverage and financial leverage. Combined leverage = Operating leverage X financial leverage  = % change in EBIT / % change in sale X % change in EPS / % change in EBIT

13. Thank You