Question

The capital structure of a company mostly depends on the earning capacity of the business” Justify the statement with example

Answer 1

Capital Structure of a company means the proportion of Equity, Retained Earnings and Debt in the total Capital Employed by the company.

1) Retained earnings are a direct result of the profitability of the company. HIgher the profitability, higher the retained earnings (given dividend does not increase).

2) Debt capital on the other hand remains fixed but is also a factor of company's profitability since if the company does not earn enough to cover its debt obligations (Interest + principal), it cannot survive. Debt is also beneficial for the company as it creates a tax shield since interest is tax deductible expense. So, if a company wants to take borrowings in its capital structure, it must earn enough to cover its debt obligations.

3) Equity is amount contributed by the owners of the company. They are the last stakeholeders who are entitled to their profit share after debt owners are paid. But they are the first stakeholder to create the company and take it to a respectable level of earnings after which debt holders agree to provide debt capital. Initially, company is entirely funded by equity capital since there are no retained earnings and debt owners do not have track record of company which gives them confidence to lend their capital.

For eg - Ferrari company. When the company launched its IPO in 2014, it had only 8 % debt. In 2020, it has 58% debt in its capital structure and is taking the advantage of Financial leverage, which is nothing but earning more than cost of debt and providing balooned returns to equity share holders.