MFM Unit-2
What is a 'Financial Structure'?
Financial structure refers to the specific mixture of long–term debt and equity that a company
uses to finance its operations. The composition directly affects the risk and value of the
associated business.
Like the capital structure, the financial structure is divided into the amount of the company's
cash flow that goes to creditors and the amount that goes to shareholders. Each business has a
different mixture depending on its needs and expenses. Therefore, each company has its own
particular debt-equity (D/E) ratio.
While designing an optimum capital structure the following factors are to be con sidered
carefully:
1. Profitability:
An optimum capital structure must provide sufficient profit. So the profitability aspect is to be
verified. Hence an EBIT-EPS analysis may be performed which will help the firm know the EPS
under various financial alternatives at different levels of EBIT. Apart from EBIT-EPS analysis
the company may calculate the coverage ratio to know its ability to pay interest.
2. Liquidity:
Along with profitability the optimum capital structure must allow a firm to pay the fixed
financial charges. Hence the liquidly aspect of the capital structure is also to be tested. This can
be done through cash flow analysis. This will reduce the risk of insolvency. The firm will
separately know its operating cash flow, non-operating cash flow as well as financial cash flow.
3. Control:
The supplies of debt have no role to play in managing the firm; but equity holders have right to
select management of the firm. So more debt means less amount of control by the supplier of
funds. Hence the management will decide the extent of control to be retained by themselves
while designing optimum capital structure.
4. Industry Average:
The firm should be compared with the other firms in the industry in terms of profitability and
leverage ratios. The amount of financial risk borne by other companies must be con sidered while
designing the capital structure. Industry average provides a benchmark in this respect. However
it is not necessary that the firm should follow the industry average and keep its leverage ratio at
par with other companies; however, the comparison will help the firm to act as a check valve in
taking risk.
5. Nature of Industry:
The management must take into consideration the nature of the industry the firm belongs to
while designing the optimum capital structure. If the firm belongs to an industry where sales
fluctuate frequently then the operating leverage must be conservative.
In case of firms belonging to an industry manufacturing durable goods, the financial leverage
should be conservative and the firm can depend less on debt. On the other hand, firms producing
less expensive products and having lesser fluctuation in demand may take an aggressive debt
policy.
6. Maneuverability in Funds:
There should be wide flexibility in sourcing the funds so that firm can adjust its long-term
sources of funds if necessary. This will help firm to combat any unforeseen situations that may
arise in the economic environment. Moreover, flexibility allows firms to avail the best
opportunity that may arise in future.
7. Timing of Raising Funds:
