Financial Structure
Financial structure plays a critical role in shaping the form, strategy and decision making processes of a business. It can also be referred to as financial architecture, which is defined as the way in which a company chooses to finance itself and how the various sources of capital are structured. In the context of this article, it is concerned with the combination of debt, equity and other sources of financing used by businesses.
The choice of the most appropriate financial structure for a business depends on many factors. These can include the competitive industry environment, the firms competitive strategy and its risk tolerance. Additional considerations include the cost of external funding, taxation and the availability of capital in the financial markets.
Debt
Debt comes in many forms. It can be either short-term borrowings such as overdrafts and bank loans, or longer-term debt such as bonds and mortgages. The structure of these borrowings is key, as it affects the financial structure of a company and subsequently its credit rating. Short-term borrowings allow a company to fund its short-term obligations and bridge cash-flow gaps; whereas long-term borrowing is often used to fund large capital expenditure or acquisitions.
In addition to the actual debt instrument, firms must also carefully consider the associated interest rate risks. Interest rates can be fixed or floating (adjustable); with fixed rates offering greater certainty but higher interest payments when rates are falling. Floating interest rates are more flexible and are more commonly used amongst businesses with higher levels of uncertainty.
Equity
Where debt is used to finance the operations of a company, equity is used to fund its growth. Equity capital is often referred to as ‘permanent’ capital, as it is expected to remain with the company in perpetuity and grow with the business. The form of the equity may vary; the most common being common shares although various classes of shares can exist, such as preferred or deferred shares.
The form of the equity financing also impacts on the governance structure of the company. Public markets provide equity investors with a degree of protection, giving them representation on the board and the ability to dictate strategies through the voting process. Where a company has not gone to the equity markets, private equity investors are increasingly used. These investors provide less shareholder protection, however, often have far more direct control over their investments.
Alternative Financing
In addition to debt and equity, private companies often take advantage of alternative forms of financing. These can include venture capital, convertible debt, leasing and subordinated debt. These are often used in conjunction with longer-term debt and equity and avoid the need for external financing from more traditional lenders.
Conclusion
Financial structure is a defining factor for the success of a business. Careful consideration should be given to the form, cost and availability of any capital raised. To ensure a successful and sustainable business, firms must choose the right form of capital, the right structure of debt and the right ownership of equity.
