The Capital Structure of Entity

Question: Write an essay onThe capital structure of an entity . Answer: Introduction The capital structure of an entity presents how the entity finances its operations with the help of different sources of funds. The financial structure of an entity is the balance between all the liabilities and equity. It is the mix of long term and short term sources of funds used by a firm. It is the mix of debt and equity funds of an enterprise. It is important for an entity to have an optimal debt equity balance which generates the maximum value for the firm. The optimal debt equity mix should be such that the cost of capital for the entity is the least. The financial structure of the firm is very important, as the whole of the operations of the company is dependent on its finance (Vanderbeck, 2013). Healthy finance gives healthy and smooth functioning activities. Equity The equity capital represents the difference between value of assets and cost of liabilities. As per company accounts equity refers to shareholders equity. Equity is the cheapest source of finance. A negative equity is called as shareholders deficit. The equity shareholders of a company are the shareholders of the company who invest in the company by buying the equity shares of that company in anticipation of earning dividends. When a company is formed it needs capital in order to operate its business, so the company raises capital by issuing equity (Needles Powers, 2013). The shareholders subscribe to the share of the company and then the shares are allotted. Now, this becomes the permanent capital of the company which needs not be refunded. Only at the time of liquidation after payment of all the liabilities if any amount is left is distributed among the shareholders proportionately. The equity fund is dedicated wholly for the operations of the entity. The value creation of the shares is a source of investment appraisal for the equity shareholders. The best part of equity fund is that is has no associates costs unlike debt funds. The option to pay dividend is in the hands of the company (Vanderbeck, 2013). Even if the company earns sufficient profits the company is not obligated to pay dividends because the investors totally understand that the funds are really important for the growth of a company. Also the equity funds help to maintain the leverage of the company (Needles Powers, 2013). There is no obligation on the part of the company to pay back the funds. But the main drawbacks of equity financing is that, raising equity as a source of finance is demanding, costly and a time consuming method. It may require a lot of attention of the management. In order to raise equity, the company needs to have comprehensive check on its background and past performance, this if very often required by the potential investors. The company has to spend a lot of resources and time on this irrespective of the fact if it manages to raise any fund or not. Also there are a lot of legal and regulatory norms which are to be taken care of before raising funds through equity (William, 2010). Therefore, we see that equity as a source of finance is one of the best ways to raise capital for a business. It has a lot of advantages and one of the cheapest sources of finance. The only problem which lies is the issues related to its procurement. The company needs to build up an image and keep up progressive work if it desires to keep the business funded by equity. Overall, equity represents the own funds of a company. Debt The debt portion of the capital of a company represents the cash borrowed by the company at a fixed rate of interest with a fixed date or intervals to repay it. Debt may be represented by a loan or sale of debentures, the form will not change the nature of the debt. The lender always has the right to get back his money he lends along with the interest or as the agreement specifies (Needles Powers, 2013). Lending to a company to a company in theoretical terms is safer than in practical world. Investment through debt from lender point of view is more risky and it also provides higher awards. The performance of the company is the whole basis for procurement of loan. If the company has a good asset base with continuous profits then they can easily procure loans from the market. The main advantages of debt financing include no participation of outsiders in the business. When a company raises fund through a loan, the lender will not be there to tell the management on how to use the funds, it be the wholly decision of the management. Once the loan is repaid, the relationship with lender comes to an end unlike equity funding. Another advantage of debt financing is tax savings (Needles Powers, 2013). The interest paid in connection with loan is tax deductible and helps the companies to reduce its tax burden. Also when a company has taken loan it knows from before at what time and intervals is it required to pay interest along with exact numbers. This way the company can prepare its budget and check for availability of funds accordingly. The disadvantages of debt financing is that the companies need to have a good credit rating in order to procure loan, else it would the terms and conditions of loan shall be very harsh on the company. The company will have to maintain a series of smooth cash flow so that it is always has availability of funds to pay back loan instalments and interest amounts. If the lender would require collateral in connection to a loan provided by him, then this can bring the assets of the company at risk. So in order to decide if to or not to use debts as a financing tool the management needs to answer a few questions. It needs to check if it wants to have full control over the business of the company. Also, it needs to know it can pay back the loan timely and efficiently and if it would be comfortable in doing so. The company needs to check its credit worthiness before taking a loan and also it the worthiness is enough to get the company the desired amount of debt (Horngren, 2013). The management of the company needs to check it has sufficient assets to provide as collateral for the loan. Comparison of Debt and Equity of two companies For the assessment we have chosen two biggest retails which are listed on the London stock exchange, the first is Kingfisher Plc which has a market cap of 7237.25 million and the other is Next Plc which has a market cap of 7368.98 million. We have calculated few liquidity ratios for both the companies for better understanding and comparability. Debt Equity Ratio: the D/E ratio is a finance ratio which helps the entity to measure its financial leverage. It helps the company to calculate what part of its capital is financed by debt and what by equity (Horngren, 2013). Debt Ratio: the debt ratio helps the companies to calculate what part of the companys assets is financed by debt or outside funds (Needles, 2011). Equity Ratio: the equity ratio helps the companies to calculate what part of the companys asses is financed by equity or own funds (Horngren, 2013). Interest Coverage ratio: this ratio helps the investor to calculate the companys ability to meet the interest payments as they fall due. Earnings per share: this ratio helps the investor to calculate profit earned on each share of the company. Analysis of Debt and Equity of Kingfisher Plc Kingfisher Plc is the largest home improvement retailers of Europe and the third largest in world. It has its headquarters situated in London. It has around 1176 stores in across 11 countries all over the world (Kingfisher Plc, 2015). Following are the equity, debt and asset components of the company for last five years: 2016 2015 2014 2013 2012 Total Debt 3508 3474 3503 3741 3906 Total Equity 6186 6239 6317 6156 5727 Total Assets 9,694 9,713 9,820 9,897 9,633 We see that the company has over the period of five years tries to maintain is debt is to equity ratio of near about 0.5 to 0.7. This shows that the company is properly leveraged and there are no major variances in the financing of the company. The capital structure of the company is consistent and is healthy. Analysis of Debt and Equity of Next Plc Next Plc is another one of the largest clothing, footwear and home products retailers with about 700 stores. It is the largest clothing retailer of England, having left behind Marks and Spencer in the year 2012 and 2014 (Next Plc Ltd, 2015). Following are the equity, debt and asset components of the company for last five years: 2016 2015 2014 2013 2012 Total Debt 2,018.30 1,960.40 1,858.40 1,608.00 1,631.50 Total Equity 311.80 321.90 286.20 285.60 222.70 Total Assets 2,330.10 2,282.30 2,144.60 1,893.60 1,854.20 We see that the capital structure of Next Plc is not very balanced. The proportion of debt as compared to equity is very high. This indicates that most of the operations and assets of the company are financed by loan funds (Lanen, 2008). The company is under huge obligation and it needs to take measures to improve its equity capital base. Comparison of the ratios of two companies Debt Equity Ratio Debt Equity Ratio 2016 2015 2014 2013 2012 Kingfisher Plc 0.57 0.56 0.55 0.61 0.68 Next Plc 6.47 6.09 6.49 5.63 7.33 The healthy debt to equity ratio lies within 0.5 to 2 depending on the industry in which the company operates. We see that Debt equity ratio of Kingfisher Plc is normal whereas that of Next Plc has crossed the threshold of 2. It is a bad sign for the company and the management of Next Plc needs to take some measures in order to correct it. Debt Ratio Debt Ratio 2016 2015 2014 2013 2012 Kingfisher Plc 0.36 0.36 0.36 0.38 0.41 Next Plc 0.87 0.86 0.87 0.85 0.88 Debt ratios of 0.4 or lower are considered well whereas ratio of 0.6 or more is not considered healthy. The debt ratio of kingfisher Plc has maintained over the period of 4 years and is below 0.4. But the debt ratio of Next Plc is very high and is not appropriate. It represents high leverage which can bring the company at stake (Horngren, 2013). Equity Ratio Equity Ratio 2016 2015 2014 2013 2012 Kingfisher Plc 0.64 0.64 0.64 0.62 0.59 Next Plc 0.13 0.14 0.13 0.15 0.12 The equity ratio of 0.6 and higher is considered good and ratio of 0.4 and below represents financial instability for the company. Kingfisher Plc has maintained its equity ratio around 0.6 over the period of five years. But the equity ratio of Next Plc is not appropriate. This represents that the company is mostly financed by loan funds. Interest Coverage Ratio Interest coverage Ratio 2016 2015 2014 2013 2012 Kingfisher Plc 24.27 50.54 64.25 37.37 26.71 Next Plc 26.44 25.45 24.54 22.97 19.82 Higher the interest coverage ratio better it is for the company. We see that the interest coverage ratio of Kingfisher Plc is not very stable but still at a better position than next Plc. The level of interest coverage ratio for Next Plc has maintained a steady form, but still the company needs to improve its performance, Earnings Per Share Earnings Per Share 2016 2015 2014 2013 2012 Kingfisher Plc 17.77 24.19 29.76 23.77 26.95 Next Plc 442.57 419.62 366.12 297.80 282.01 The earnings per share dont determine the performance of the company; it is the wealth maximization on which the company should focus. We see that EPS level of Kingfisher is very low as compared to Next Plc, this is so because of the debt equity ratio. The capital structure of Kingfisher has a higher proportion of Equity as compared to Next plc. Having more debt in capital structure creates a lot of burden on the company. Recommendation From the above calculations and graphs it is very clear that the capital structure of Kingfisher Plc is healthy and needs no changes, whereas the capital structure of Next Plc is very inappropriate and is highly levered. The capital structure of Next Plc requires immediate attention. The liquidity of the company will be at stake if the company continues to use this proportion of loan funds from outsiders. Even though Next Plc is the largest cloth retailers with highest revenue; the liquidity of the company if not proper can result in tremendous losses to the company (Albrecht et. al, 2011). Conclusion Equity and debt plays a vital role in shaping the destiny of the company and a comprehensive evaluation of the company considering these two provides a clear-cut picture. In the above report too, the comparison is done between Kingfisher Plc and Next Plc with the help of equity and debt. Therefore we see that proper generation of operating revenues is not the only feature which determines the financial position of the company. The capital structure of the company plays a very important role in determining the financial status of the company (Shim Siegel, 2009). References Albrecht, W., Stice, E. Stice, J 2011, Financial accounting, Mason, OH: Thomson/South-Western. Horngren, C 2013, Financial accounting, Frenchs Forest, N.S.W.: Pearson Australia Group. Kingfisher Plc 2015, Kingfisher Plc Annual Report and accounts, viewed 8 July 2016, https://www.kingfisher.com/index.asp?pageid=61 Lanen, W. N., Anderson, S Maher, M. W 2008, Fundamentals of cost accounting, NY: Hang Loose press. Needles, B. E. Powers, M 2013, Principles of Financial Accounting. Financial Needles, S. C 2011, Managerial Accounting, Nason, USA: South Western Cengage Learning. Next Plc Ltd 2015, Next Plc Ltd. Annual Report and accounts 2015., viewed 8 July 2016, https://www.nextplc.co.uk/~/media/Files/N/Next-PLC-V2/documents/reports-and-presentations/2014/next-annual-report-2015-final-web.pdf. Shim, J.K Siegel, J.G 2009, Modern Cost Management and Analysis, Barron's Education Series Vanderbeck, E. J 2013, Principles of Cost Accounting, Oxford university press William, L 2010, Practical Financial Management, South-Western College.