Capital Structure: Meaning and Basic Principles

Once a business decides how much fixed capital and working capital it requires in total, the next question is: in what proportion should this money be raised from different long-term sources? The answer to this question is what the AP Intermediate Commerce syllabus calls capital structure.

Capital structure means the mix or proportion of different kinds of long-term funds — mainly owned funds (equity share capital, preference share capital and retained earnings/reserves) and borrowed funds (debentures and long-term loans) — that a company uses to finance its total assets. For example, a company financing its assets with sixty percent equity capital and forty percent debentures and long-term loans has a very different capital structure from one that relies on ninety percent equity and only ten percent borrowed funds.

It is useful to distinguish capital structure from the broader idea of financial structure. Financial structure refers to the entire left-hand side of a balance sheet — that is, all sources of funds, both long-term and short-term (including current liabilities). Capital structure is narrower: it looks only at the long-term, permanent sources of finance and ignores short-term borrowings such as trade credit or a bank overdraft. …