Definition of Capital Structure

This time we will discuss the definition of capital structure and the components and factors that affect the capital structure. Here’s the explanation …

Table of contents :

  • Definition of Capital Structure
  • Factors Affecting Capital Structure
  • Capital Structure Components
    • Foreign Capital
    • Own Capital
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Definition of Capital Structure

The capital structure is the financial proportion between short-term debt, long-term debt and equity when carrying out company work.

This is an important problem for the company because a bad capital structure will have a direct impact on the company’s financial position.

The following are some ideas about capital structure from several book sources:

According to Halim (2007: 78)

The capital structure is a balance of the amount of fixed short-term debt, long-term debt, preferred stock, and common stock.

In capital structure theory, it is stated about whether changes in capital structure affect firm value, assuming that investment decisions and dividend policies do not change.

According to Raharja Putra (2009: 212)

The capital structure is a mixture of long-term debt and equity, in order to fund the company’s investment (operating assets).

In business activities, determining the right capital structure is a challenge for company executives.

The company will strive to raise funds with minimal capital costs with maximum results.

According to Sawir (2008: 10)

The capital structure is permanent funding consisting of long-term debt, preferred stock, and shareholder capital.

The book value of shareholder capital consists of ordinary shares, paid up or surplus capital, capital and accumulated ownership. Capital structure is part of the financial structure.

According to Rodoni and Ali (2010)

Capital structure is the proportion in determining the fulfillment of company expenditure needs where funds are obtained using a combination or combination

 

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sources originating from long-term funds which consist of two main sources, namely those from within and outside the company.

Factors Affecting Capital Structure

The optimal capital structure is one that can minimize the cost budget by using the overall capital or the average cost of capital, so that it will maximize firm value.

There are four factors that affect the capital structure, as follows (Brigham and Houston, 2001: 6):

  1. Business risk. The level of risk contained in the company’s operations if it does not use debt. The greater the company’s business risk, the lower the optimal debt ratio.
  2. The company’s tax position. The main reason for using debt is that interest costs are deductible in the calculation of taxes, thereby reducing the true cost of debt.
  3. Financial flexibility. Ability to raise capital on reasonable terms in deteriorating conditions. Company fund managers know that a strong provider of capital is necessary for stable operations, which is a critical factor in long-term success.
  4. Conservatism or management aggressiveness. Some management is very aggressive than others, so that some companies prefer to use debt to increase profits. This factor does not affect the optimal or value-maximizing capital structure, but will affect the targeted capital structure set by the manager.

Capital Structure Components

The capital structure component consists of foreign capital and own capital, with the following explanation (Riyanto, 2008: 227):

1. Foreign Capital

Foreign capital or debt is capital that comes from outside the company while working inside the company and for the company concerned capital is a debt which must be paid off in due time.

In making decisions regarding the use of debt, one must consider the amount of fixed costs that arise from debt

 

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in the form of interest which would lead to increased financial leverage and an increasingly uncertain rate of return for common stockholders.

Foreign capital or foreign debt is divided into three types, namely as follows:

  • Short-term Debt

Short-term debt is foreign capital with a maximum period of one year. Most short-term debt consists of trade credit, which is credit needed to run the business.

  • Intermediate-term Debt

Medium-term debt is debt more than one year or less than 10 years. Medium-term debt is divided into two, namely Term Loans and Leasing. Term Loan is a business loan with an age of more than one year and less than 10 years.

Leases are a tool or a way to get services from fixed assets which are basically the same as if we sell bonds in order to obtain services and owner’s rights to these assets, the difference in the lease is not accompanied by ownership rights.

  • Long-term Debt

Long-term debt is debt with a long term, generally more than 10 years. Long-term forms of debt include bond loans and mortgage loans.

Bond loans are loans for long periods of time, for debtors to issue debt certificates that have a certain nominal value.

A mortgage loan is a long-term loan where the money provider (creditor) is given a mortgage right on immovable property, so that if the debtor does not fulfill his obligations, the goods can be sold from the sale and can be used to cover the bill.

2. Own Capital

Own capital or equity is basically capital that comes from the owner of the company and which is embedded in the company for an indefinite period of time.

 

Also Read:   Understanding Venture Capital

 

Own capital is expected to remain in the company for an indefinite period while the loan capital is due.

Own capital in a company is divided into several types, namely:

  • Capital stock

Capital stock is evidence of the return part or participants in the company. The types of shares include common stock, preferred stock, cumulative preferred stock and others.

  • Reserve

Reserves here are intended as reserves that are formed from the profits that the company has earned for some time or from the current year.

Reserves include own capital including expansion reserves, working capital reserves, foreign exchange reserves, reserves for storing goods or unexpected events (general reserves).

  • Retained earning

Profits or profits earned by the company can be paid partly as dividends and partly held by the company. If the profit holding has been for a specific purpose, then the reserve is formed as described.

If the company does not have specific objectives regarding the use of these benefits, then profit is the profit that is retained.

 

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