Abstract
Capital structure means an organization’s utilization of equity and debt to acquire new assets and finance its operations. Structure is a term that refers to an arrangement of various components. This means that capital structure is essentially an arrangement of capital drawn from various sources to raise the required long-term business funds. A modern business’ ability to issue secured debt is dependent on how tangible its assets are. Businesses with more tangible assets would have an easier time and process when issuing secured debt. Organizations that experience high-growth opportunities are likely to also be a lot more leveraged. The link between leverage and the size of the organization is important. This is because bigger companies tend to diversify their sources of financing.
In perfect markets, the self-financing and financing options would not alter an organization’s value and various investment projects. Getting the required financial resources, both long-term and short-term, and the financiers’ remuneration that provides the company funds involves specific capital utilization costs. When it comes to the source of capital, organizations should consider some aspects. Romania is the country that was selected for the research into capital structures. The country’s economy has a history of centralism and domination of management styles that are engineering-based. The research analyzes the effectiveness of techniques and methods for evaluating a company’s success and financial structure. An organization’s debt capacity ratio is examined by comparing its total debt to its total assets.
Introduction and Overview
Capital structure means an organization’s utilization of equity and debt to acquire new assets and finance its operations. A modern organization’s capital structure is useful for evaluating its risk profile, financial health, and compatibility with its acquisition or investment approaches. Understanding the prevailing interplay and dynamics of equity and debt and the role they play in the capital structure of various organizations are crucial aspects of any modern investor’s toolkit that will assist them in evaluating the overall viability of a specific target or investment. It also helps the business to determine the new investment’s potential for growth.
Capital structure is a crucial determinant of a company’s success and financial health. Structure is a term that refers to an arrangement of various components. This means that capital structure is essentially an arrangement of capital drawn from various sources to raise the required long-term business funds. Therefore, capital structure means a combination or proportions of equity share capital, debentures, preference share capital, long-term loans, retained earnings, and other viable sources of funds. This report explores the role that capital structure plays in the success and establishment of a business organization. This is done by focusing on low debt to equity ratios and high debt to equity ratios and their effects on a modern business organization.
Review of the Literature
Organizations that experience high-growth opportunities are likely to also be a lot more leveraged. In cases of businesses that are still in their formative steps, it is believed that the high-growth businesses require some external financing, which could also be highly leveraged (Anuar & Chin, 2016). Studies have shown a positive correlation between a firm’s growth and its debt accrues. The latest undertakings are usually presented to shareholders and investors as lucrative growth opportunities (Anuar & Chin, 2016). They often have to deal with problems of under-investment. This could contribute to them forgoing investment projects with positive net present values.
A modern business’s ability to issue secured debt depends on how tangible its assets are. Businesses with more tangible assets would have an easier time and process when issuing secured debt. An organization with a high proportion of fixed assets can borrow at relatively lower interest rates by listing the assets as collateral. Restrictions on the maturity length of the credit that the various lenders provide could end up partially explaining SMEs’ debt structures (Anuar & Chin, 2016). Studies point towards a positive correlation between long-term debt and assets’ structure. However, there is a negative relationship when it comes to short-term debt.
Research into debt to equity ratios shows a negative correlation between an organization’s profitability in both long-term and short-term debts. Organizations tend to make use of internal resources to fund their operations. However, some studies have shown no viable evidence of a relationship between profitability and leverage. Lenders tend to avoid dealing with organizations that have low-level profits. Elements like liquidity address the aspect of stock sufficiency (Anuar & Chin, 2016). When it comes to debt and equity ratios, liquidity provides an insight into the stock of viable liquid assets that can be used to meet short-term liquidity needs under specified acute stress scenarios. A firm’s leverage and its liquidity are positively related. The relationship between capital structures and liquidity should be considered. This is because liquidity significantly affects a business’ debt ratios (Bărbuţă-Mişu & Bodea, 2014). Companies that have record-high liquidity ratios could end up having significantly high debt ratios. This is primarily because of their higher ability to meet short-term financing obligations.
The link between leverage and the size of the organization is important. This is because bigger companies tend to diversify their sources of financing. This is not witnessed in smaller organizations since they rely on either a single lender or support from family and friends. This shows that its size is significant with its leverage (Anuar & Chin, 2016). There are also some notable differences in debt maturity structures between large and small organizations. An organization’s size and long-term debt have positive relationships. However, there is a negative relationship between short-term debt and the organization’s size. Studies have also shown that age is crucial when studying a firm’s capital structure (Anuar & Chin, 2016). Generally, financing institutions evaluate a firm’s creditworthiness over a specific period. The younger the organization, the lower its ability to access external financing. Companies that have been in operation for less than five years tend to depend on informal financing (Anuar & Chin, 2016). They are also less dependent on formal channels such as bank financing. Older companies tend to take in more debt ratios to expand their businesses. This shows that the company’s age is more often positively correlated with debt.
In perfect markets, the self-financing and financing options would not alter an organization’s value and various investment projects. However, the market cannot be described as being perfect. This is primarily due to the shareholders’ fiscal treatments of their loans and capital gains (Bărbuţă-Mişu & Bodea, 2014). Both the dividend decisions and the financing decisions could influence the company’s value and its investment decisions. Generally, financing structures can determine the extent of tax savings with a rise in the rates of indebtedness (Bărbuţă-Mişu & Bodea, 2014). A profitable organization will always have access to capital to finance its various projects, even in cases where the financial structure of the entity is in debt. Other than this, the leverage effect would positively affect the company’s overall profitability if the overall return rate is more than the prevailing interest rates.
Getting the required financial resources, both long-term and short-term, and remuneration of the financiers that provide the company funds usually involves specific capital utilization costs. These aspects should be considered when decisions touching on finance are being made (Bărbuţă-Mişu & Bodea, 2014). The utilization of any other financial resources usually attracts some costs in one form or another (Bărbuţă-Mişu & Bodea, 2014). One of the tasks of the management involves developing sufficient financial plans to better satisfy the various needs of financial resources due to the business’ evolution under a particular risk-return ratio (Bărbuţă-Mişu & Bodea, 2014). Similarly, the utilization of long-term capital usually entails meeting the creditors’ expectations while also rewarding any shareholders with attractive returns.
When it comes to the source of capital, organizations should consider some aspects. One of these aspects is the financer’s experience when it comes to granting credit to organizations from the concerned industrial sector. The financer is supposed to be familiar with issues that the organization and its industry are facing (Bărbuţă-Mişu & Bodea, 2014). Few businesses can hire experienced staff members to specifically deal with their financial problems. This is why organizations have to get capital from entities that have experience in dealing with their specific kind of funding (Bărbuţă-Mişu & Bodea, 2014). The financer’s reputation has also been determined to be a crucial aspect to consider. The organization’s success is, at times, based on the quality of the relationship between the financier and the management. The financer should enjoy a reputation of fairness, honesty, and willingness to work with the company in question. The financer must provide the needed assistance in getting capital. This is crucial for organizations that do not enjoy the experience in specific areas, and they require some experienced insights into the segment.
Methodology
Romania is the country that was selected for the research into capital structures. The country’s economy has a history of centralism and domination of management styles that are engineering-based. The country’s change from a primarily centralized economy to a competitive one came with significant changes in its companies’ accounting and financial management practices. Accounting and financial activity should be organized such that they provide the company’s shareholders and other notable decision-makers with fair and objective information (Bărbuţă-Mişu & Bodea, 2014). The information should be closely related to the company’s market value, its position within the market, and information touching on the level of the business’ vulnerability in various market contexts (Bărbuţă-Mişu & Bodea, 2014). This enables them to embrace the most suitable funding sources for their financial situation.
The research analyzes the effectiveness of techniques and methods for evaluating a company’s success and financial structure. Numerous financing methods and options are presented based on the results of an analysis of various indicators (Bărbuţă-Mişu & Bodea, 2014). The indicators have a crucial role since it helps the organization’s managers decide the kind of financing that the business should utilize depending on the shortage of resources and financial autonomy on both short-term and long-term aims for each firm. An analysis of five businesses was made. These companies are operating in the country’s industrial and metal segments. The sector’s capital structure decisions are mostly driven by a variety of aspects (Bărbuţă-Mişu & Bodea, 2014). These factors include debt capacity, financial flexibility, and ROE. Financial flexibility refers to the organization’s ability to raise the required capital on favorable terms in difficult circumstances within the economic environment (Bărbuţă-Mişu & Bodea, 2014). Besides the mentioned indicators, businesses also utilize various rates that establish normal and acceptable limits. This is done according to the estimated negative or positive impacts of borrowing on the organization’s management. These include interest coverage, long-term debt, and financial autonomy rates.
An organization’s debt capacity ratio is examined by comparing its total debt to its total assets. If the result is less than or equal to two-thirds, the results show there is favorable leverage. If the ratio is equal or greater to two-thirds, then the result is an unfavorable or negative leverage impact (Bărbuţă-Mişu & Bodea, 2014). ROE is described as an indicator of the organization’s profitability by determining the amount of profit the organization generates with the money that the owners of common stock have invested. ROE helps to highlight business earnings that have resulted from each currency unit’s equity.
Long-term debt ratios show the proportions of long-term debts to the organization’s permanent capital (Bărbuţă-Mişu & Bodea, 2014). If the long-term debt is more than the permanent capital, then the organization would have a relatively high level of debt which means it has negative equity (Bărbuţă-Mişu & Bodea, 2014). In such a case, the long-term debts should represent at most fifty percent of the business’ permanent capital (Bărbuţă-Mişu & Bodea, 2014). This is the equivalent of a value that is less than or equal to fifty percent, or if it is expressed as a coefficient, it should be equal to or lower than 0.5 (Bărbuţă-Mişu & Bodea, 2014). The interest coverage ratio is calculated by dividing earnings before taxes and interests by the interest payment. If interest expenses are more than earnings recorded before taxes and interests, the company’s indebtedness ends up becoming unbearable. It would end up dragging down the company’s profitability (Bărbuţă-Mişu & Bodea, 2014). During such a situation, the equity capital is equal to or larger than the long-term and medium debts. This would mean that the rate of long-term financial autonomy is higher or more than 1.
Results and Analysis
To accurately highlight how such indicators impact an organization’s capital structure, the study considered five Romanian entities within the heavy industrial segment. The companies that were analyzed included Alum Tulcea, ArcelorMittal Hunedoara, Dan Steel Group Beclean, Mechel Campia Turzil, and Laminorul Braila. In the list of companies, ArcelorMittal recorded the highest debt capacity ratio during this period. The ratio was between 22% and 48%. It was also worth noting that Alum had a significant share of total debt in terms of total liabilities ranging from 17% to 38% (Bărbuţă-Mişu & Bodea, 2014). The organization registered a rising trend during the period being analyzed.
When it came to ArcelorMittal, high debt value capacity demonstrated the difficulties that the company experienced that were linked to short-term payment obligations through the utilization of their resources. This scenario is also sustained by the values that have been recorded based on the indicators like return on equity and interest coverage ratios (Bărbuţă-Mişu & Bodea, 2014). These aspects show that the firm has no long-term debts uncovered but is faced with net losses of its resources that impede it when covering short-term debts. Laminorul’s short-term debt capacity ratios recorded values that ranged between six percent and twelve percent (Bărbuţă-Mişu & Bodea, 2014). These figures show that the organization is not dealing with any problems, especially regarding long-term debt financing. However, during this period, the firm did not record any profits that could allow it to meet funding costs.
The evolution of returns on equity showed that Dan Steel Group Beclean had positive net incomes during the analysis period. This was reflected in return on equity that ranged between fourteen percent and 19.4%, with a notable decreasing trend (Bărbuţă-Mişu & Bodea, 2014). Alum and ArcelorMittal were profitable during this period; however, Laminorul recorded declining returns on equity (Bărbuţă-Mişu & Bodea, 2014). The companies’ interest coverage ratio showed that only Dan Steel Group Beclean could absorb any interest from earnings before taxes and interest (Bărbuţă-Mişu & Bodea, 2014). However, the organization still recorded reduced earnings. Although Mechel and Alum recorded positive earnings before taxes, the financial activity generated losses during the same period (Bărbuţă-Mişu & Bodea, 2014). Alum recorded general financial stability. The stability was good enough when considering the indicator’s evolution which determines the company’s financial autonomy. Mechel recorded the highest state of financial autonomy ratio. This was demonstrated by the sub-unitary value of the financial long-term debt ratio (Bărbuţă-Mişu & Bodea, 2014). This means that the permanent capital exceeded any long-term financial debts that the company had taken in.
Generally, an evaluation of the organizations showed that the indicators had a fluctuating trend that exceeded optimal value during specific periods. This is a positive effect but at times with values below normal limits, which illustrated changes in the organizations’ financing structure. For all the entities that have been analyzed, the debt capacity ratio recorded values that fell below fifty percent (Bărbuţă-Mişu & Bodea, 2014). This shows that they were not very successful (Bărbuţă-Mişu & Bodea, 2014). They encountered difficulties in meeting debt payments using their resources. The rate of financial autonomy shows the ability of the organizations to meet debt obligations using their resources. In the case of the organizations analyzed, it was noticed that there was a fluctuating trend with a tendency to increase towards the end of the considered period.
Conclusions and Future Research
The primary concern of this report was to evaluate the significance of capital structure and financing in a business organization’s activity. It also explored the role of capital structure in the choices of funding sources. Most of the businesses discussed had a significant debt capacity. However, this had to be correlated with the proportion between equity and debt and desired profitability. It could be stated that Dan Steel Group Beclean enjoyed an optimal capital structure which means that it had approximately 94% equity with only 6% as debt (Bărbuţă-Mişu & Bodea, 2014). This situation generated a return on equity that ranged from between fourteen percent to 19.4%. A higher debt proportion was strongly correlated with a recording of losses, such as in ArcelorMittal’s and Alum’s case (Bărbuţă-Mişu & Bodea, 2014). This means that the main con related to optimal capital structure in the case of organizations within this industry is that highly leveraged companies are not successful. They tend to record poor performances. Only businesses that utilize their funds when financing their investments tend to record higher returns on equity. It was also noted that a capital structure with high debts tended to reduce the ability to get new external funds from other creditors (Bărbuţă-Mişu & Bodea, 2014). In the future, research should be conducted on the acceptable level for organizations to get into debt while still maintaining robust performance. This is because it is inevitable for businesses to seek debt to finance their growth and strategies. It is crucial to determine just how much debt is considered healthy debt for most businesses.
References
Anuar, H., & Chin, O. (2016). The development of debt to equity ratio in capital structure model: A case of micro franchising. Procedia Economics and Finance, 35, 274-280.
Bărbuţă-Mişu, N., & Bodea, M. F. (2014). The Role of Capital Structure in Company’s Financing. Annals of the University Dunarea de Jos of Galati: Fascicle: I, Economics & Applied Informatics, 20(3).
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