Q.What is meant by capital structure?

Capital structure refers to the mix between a company's owners' funds and borrowed funds used to finance its long-term operations -- that is, the proportion of debt and equity in its total long-term capital. It is a permanent financing decision that determines how a firm raises the money for its long-term needs.

Its two broad components are:

• Owners' funds (equity) -- equity share capital, preference share capital, and reserves and retained earnings.
• Borrowed funds (debt) -- loans, debentures, and public deposits.

It can be measured as the debt-equity ratio or as the proportion of debt in the total capital. The mix matters because debt is cheaper (interest is tax-deductible) but riskier, since interest and repayment are obligatory, while equity is costlier but carries no fixed obligation. The proportion chosen therefore affects the firm's cost of capital, financial risk, and control.

When a business needs long-term money -- to buy machinery, build a factory, or expand -- it can raise it from two broad kinds of source. Owners' funds consist of equity share capital, preference share capital, and reserves and surpluses (retained earnings). Borrowed funds take the form of loans, debentures, and public deposits. The mix between these owners' and borrowed funds is what we call the capital structure of the firm.

It can be measured as the debt-equity ratio -- Debt divided by Equity -- or as the proportion of debt out of the total capital, that is, Debt divided by (Debt plus Equity). The proportion of debt in the overall capital is also called financial leverage.

Debt and equity differ sharply in cost and risk. The cost of debt is lower than the cost of equity, because a lender's risk is lower (a lender earns an assured return and gets the principal back) and because interest on debt is tax-deductible, whereas dividends are paid out of after-tax profit. But debt is also riskier for the firm: interest and repayment are obligatory, and a default can force liquidation. Equity carries no such compulsion and is, from the firm's viewpoint, riskless.

There is no single ideal capital structure for every firm. The right proportion depends on factors such as the firm's cash-flow position, its fixed operating costs, control considerations, and the state of the capital market -- which is why fixing it is a considered financial decision, not an accident.