An organization employs different types of funding to run a business smoothly. Capital Structure is a composition of different types of financing employed by a firm to acquire resources necessary for its operations and growth. Capital Structure primarily comprises of long-term debt, preferred stock, and net worth. It can be quantified by taking how much of each type of financing a company holds as a percentage of all it’s financing. Capital Structure is different from financial structure as this includes short-term debt, accounts payable, and other liabilities.

Most of the companies raises fund by equity or debt. Debt comes in the form of bond or long-term notes payable, whereas equity is classified as common stock, preferred stock, or retained earnings. Both the financing has advantages and disadvantages over each other. The founders hold the ownership rights and control of the company if they raise capital by debt. The company has to pay the principal and interest to the concerned debt holders. This privilege will be lost in equity, as the shareholders become an integral part of the company. Debt financing is easier and less expensive for small firms. Payment of interest on regular becomes burden for a company and reduces their earnings. There is no obligation in equity financing to repay the money. Shareholders take a chance on good ideas for better growth opportunities of the firm.

There are two main theories of capital structure:-

Trade Off Theory

This theory proposes to increase debt levels to balance interest to shield against the cost of financial distress. The company should keep on borrowing until the marginal tax advantage of additional debt is offset by the increase in present value of the expected costs of financial distress.

Pecking Order

Companies with higher earnings should take less debt, as they require less of funding requirements due to funding met by the internal resources. A high profit making company can generate internal cash to fund their new projects.

A balance between risk and return met by capital structure is known as the most favorable capital structure. A sound capital structure aims at minimizing the risk and maximizing the profit margins. It maximizes the price of the stock and minimizes the cost of capital at the same time.