Earlier it was shown that every type of business organisation needs finances for its operations and for its growth. The finance that it needs consists of various types. e.g., long term, medium term and short term and there are different sources or channels through which such financial needs are satisfied. This latter aspect shall be discussed in greater detail in the next chapter. Another way of looking at the problem of finance is to see the form in which the total financial requirements are met. That is how much should be owned funds and how much borrowed funds. Broadly speaking the composition of liabilities side of the balance sheet is called the capital structure. According to Gerstenberg, ‘capital structure’ refers to the make-up of capitalisation. Capital structure involves the selection of securities and the determination of their proportionate amount. In fact, there is no such thing as the capital structure which may be regarded as the most appropriate either for all sorts of companies or even for the same company for all times.
According to the prospects of earnings, the capital structure of companies should be devised with different securities in such a way that it would become safe as well as economical. The general principles that guide the issues of three different types of securities, viz., debentures, preference shares and equity shares, may be stated as follows : (a) debentures should be issued by a concern that is expected to have a stable and sufficient income to pay the fixed interest charges; (b) preference shares being normally cumulative in nature can be issued when the average earnings are fairly good, though annual earnings may be of uncertain character and (c) when there is no certainty of income, equity shares should be issued. But these general principles do not help much in determining the actual proportion of different securities in the capital structure. In fact, every company is required to issue all the three types of securities and not a particular type alone that is suggested by the general principles.
The part played by long term debt, preference shares, equity shares and retained earnings depends upon several diverse factors. It is the job of the skilled financial manager first to recognise such factors and then to balance or compromise these factors in order to design the capital structure of the company under consideration. The problem of deciding the proportion of various kinds of securities is the problem of Capital Gearing. Capital gearing means the decision about the ratio of different types of securities to total capitalisation. That part of capitalisation on which fixed interest or dividend is to be paid shows gearing. Capital gearing is also called as Leverage and is the ratio between the borrowed funds (fixed return securities such as debentures preference shares, loans etc.) and the ownership securities (equity shares and reserves and surpluses not distributed to shareholders but belonging to them). Capital structure of a company is said to be ‘highly geared’ when the proportion of fixed charge bearing securities is relatively more than the ownership funds. On the other hand, a company is low geared when it raises its capital primarily by the issue of equity shares.
It is the job of the skilled financial manager to have a judicious mixture of different types of securities in the make up of capitalisation because the capital structure suitable for one company may not be suitable for another company. Gold Smith has suggested certain basic principles which must be met by every company in deciding its capital make up. Those basic principles are :
(A) The method of financing must have the power of resistance. It should be able to face the periods of loss or the gestation period. Undue dependence on fixed interest securities may endanger the very existence of a company, if it does not have regular earnings.
(B) While financing, future should not be sacrificed at the cost of present. The Scheme of financing should not be a hindrance to the fullest development of the enterprise.
(C) The over-all cost of raising capital should be kept minimum.
(D) The capital structure chosen should be simple because a simple scheme is easy to manage and avoids unnecessary suspicion in the minds of those who fail to understand the complexities of capital structure.
The aforesaid considerations are not complementary but competitive and usually contradictory. In practice, a company has to use different types of securities so, it is ‘gearing’ that requires great skill and experience in deciding the capital structure. Guthmann & Dougall have divided the factors affecting capital gearing into two parts. He terms them as conditioning factors—Internal factors and External factors. Internal factors can well be in the control of the management but external factors are normally out of control of a company, for example, capital market sentiments.