Relationship Between Proper Capital Structure And Financial Sustainability

Background of the Study

Discuss about the Relationship Between Proper Capital Structure and Financial Sustainability.

The capital structure theory and their relationship with the value of the company and their performance has been a significant issue in the process of corporate finance and literature related to accounting. Przychodzen and Przychodzen (2015) debated that under the perfect capital market scenario, which estimates that without the cost of bankruptcy and capital markets are frictionless, in case without the taxes and without the asymmetric data in the value of the company, which is looked upon to be independent from the capital framework. It is even seen that the only variables that are ascertained by the value of the company was the future power of income and therefore the capital structure decision is found to be irrelevant (Martínez?Ferrero and Frías?Aceituno 2015). From that time onwards, there are been various theories that have been constructed in order to address the capital structure of a company that is inclusive of the Pecking Order Theory, Agency Cost Theory and the Trade Off Theory.  

Even though actual extent of equity and debt may be different in somewhat over a period of time, most of the companies look to maintain their financial mix that is close to a target capital framework. The capital structure decision of a company is inclusive of the choice of the target capital framework, the aggregate maturity of their debt and the distinct kinds of financing it looks to make use of at any specific time period. In accordance to the operating decisions, Saeidi et al. (2015) explained that the managers should undertake the decisions related to the capital structure that are constructed in order to take full advantage of the intrinsic value of an organization.

Capital structure is known to be the sorts of the securities and the comparable amount that leads to capitalization. It is known to the mixture of the various sources that are long term in nature that constitutes of the preference shares, equity shares, loans that are long term and retained earnings. Dumay (2016) explained that capital structure is known to be the relationship among the several long term financial sources like debt capital, equity capital and preference shares. The decisions in accordance to the ideal capital framework is one of the significant decisions of the financial management as it is closely inter-related to the value of the organization.

Capital structure is known to be one of the significant efficient parameters on the direction and the valuation of the economic companies in the capital markets. The evolution of the environment and the present transformations leads to the fact that the rating firms with respect to credit is reliant partly to their capital framework and strategic planning that is needed in order to choose the efficient resources in order to attain the aim of wealth maximization of the shareholders (Andriof et al. 2017). It is therefore essential that the financial managers should look to maximise the wealth of the shareholders with the help of the determination of the suitable combination of the financial resources for their organizations.    

Problem Statement

In the current time period, capital structure plays a vital role in the development financial sustainability of the company. It is seen that the effectiveness of the capital structure of a firm can be observed with the extent of financial sustainability of the company. Schepens (2016) explained that creation and the development of the capital market it is seen that the assessment of the financial performance becomes one of the key topics in terms of finance. Hence, it is seen that the role of the financial aspects become vital in assessing the performance of the companies. In the current time period, the efficiency and the importance of financial decisions on the development of opportunities is known to be a measure in order to assess the performance and thereby develop the value of the companies. The perspective in accordance to the performance of a company is known to be an issue that is controversial in the aspect of finance extensively due to its multidimensional meanings. Nimtrakoon (2015) addressed the fact that performance can be assessed in two perspectives and they have been looked upon as organizational and financial in nature. It is seen that most of them are interconnected. The performance of the company can be assessed on the basis of the variables that are related to growth, returns, productivity and the extent of customer satisfaction. The level of financial performance is seen with the help of maximising the return on assets, return on equity and maximisation of profit and the return on interest is based on the efficiency of the companies. The assessments that have been explained therefore explains that capital structure is one of the significant aspect with the help of which financial sustainability can be attained and this plays a vital role in the performance of the business as well as the efficiency level in the operational activities of the organization.

There are numerous issues that needs to be taken into consideration and these aspects would be discussed in order to have an understanding of the topic and thereby the completion of the proposal. The first issue that need to be examined is inclusive of the capital framework which addressed the process with the help of which the organizations fund their entire activities and development with their capital from various sources in a way that it would make it sustainable. An effective capital structure is known to be the one that is increasingly receptive in case of emergencies (Ahlers et al. 2015). The capability of a financial plan in order to answer to the emergency problems ascertains the success of the firm. The emergency scenario may be inclusive of the variations in the revenue and availability of finance among the others. The capital framework would constitute of these emergencies and even be able to serve the debts within a timely manner.

Rationale of the Study

The other issue that is existent has been the debt to equity ratio is known to be the financial ratio that indicates the relative proportion of the equity and the debt that is utilised by the shareholders in order to finance the asset of the companies (Bolton, Mehran and Shapiro 2015). The assessment looks to ascertain the most appropriate debt, which is equity ratio which an organization needs to stay in the market depending on the kind of mix that is used by them. The main focus has been to suggest and advise to the stakeholder and the management the requirement to make effective decisions on what kind of mix that can be utilised in order to avoid this kind of insolvency.

The other issue that needs to be evaluated associates to how the management should make sure that the debts that have been taken as loan in order to finance the operational activities of the organization are the debts that are long term in nature in order to make sure that maximum amount of returns can be attained from the debts (DeAngelo and Stulz 2015). The stakeholders and the management need to even consider the opportunities of increasing the capital either of the ways of creating capital, which can be either debt or equity in nature. The main focus has been to provide the organization the most ideal model on how to obtain the best optimal framework.

Capital structure is one of the key factors that leads to the development of the financial as well as the operational framework of an organization. The stability of the business is one of the key factors with the help of which efficiency of the companies can be attained. There are several factors that are related to development of an effective capital structure and it is seen that capital structure is based on the attainment of the return on asset, return on equity, return on interest and the maximisation of profit (Brunnermeier and Sannikov 2014). There have been limited researches on the relationship among the capital structure and financial sustainability and therefore extensive steps and actions can be undertaken with the help of which the relationship can be enhanced (Véron and Wolff 2016). Every company has the intention of maximising their level of profit and therefore they look to construct plans and policies with the help of which a capital structure that is ideal for the company can be attained.

The aim of the study is to concentrate on a particular aspect in accordance to which the research would move forward and accordingly actions and steps can be attained in order to attain the same. The aim is provided as follows:

• The aim of the paper has been to ascertain how the companies can make sure that financial sustainability can be attained with the help of the incorporation of the effective capital structure

The objectives of the study are looked upon to ascertain the elements that are related to the aim of the paper. The objective of the paper is constructed as follows:

• To ascertain the how an organization can mitigate the insolvency risk with the help of the incorporation of effective capital structure with the suitable debt to equity ratio
• To ascertain the ideal debt: equity ratio of a form need to stay in the market dependent on the kind of mix up comprising of the equity and the debt that is makes use of

The research questions in association to the topic have been given as follows;

Q1. How can a firm mitigate the insolvency risk by incorporating an effective capital structure with the help of an effective debt to equity ratio?

Q2. How can management make sure that the debt that is borrowed in order to finance the operations of a firm are debts that are long term in nature in order to attain maximum amount of returns?

The initial data that is collected is related to how the decisions in association to capital structure need to be based on the cash flow and not dependent on the level of income. The cash flow in relation to debt assessment ascertain the borrowing ability of the firm. The process of undertaking decisions on the basis of the capacity of borrowing of a firm is done with the help of revenue of the firm which is inclusive of various kinds of risks as the future of the firm is very tough to forecast (Acemoglu, Ozdaglar and Tahbaz-Salehi 2015). It may even go through depressions at the specific period and it is looked upon to finance their debt, which directly leads to insolvency. The cash flow process is helpful to a firm in order to ascertain the financial environments. This permits the organizations to assess the extent of debts which the company should not exceed (Valickova, Havranek and Horvath 2015). This data would be collected with the help of interviews of management of every organizations.

This is known to be second data that will be collected by taking assistance of the literature. The trimming of cash flow need to be precise. In order for an organization to function with the help of an effective capital structure, it needs to be understood clearly the pattern of the cash flow (Fraser, Bhaumik and Wright 2015). This assists the organization to have an understanding of the suitable time in order to borrow and the time when it is not ideal to borrow relying in the pattern of the organization. This permits the organization to have knowledge of how precisely what is the kind of loan that needs to be taken which is known to the long or short term loan.

The third element that is to be collected will be with the help of the responses that would be received with the help of the management of the organization so that the present plans and policies that is utilised by the companies in order to make sure that the capital framework is ready for the transformations in the rate of interest (Guerry et al. 2015). The rate of interest has an impact on the benefits that is attained from the debts and the loans that is received by the companies. It is known that the capital structure needs to be adaptive in nature to these transformations in order to avoid the circumstances where the expenses become out of control (Ortiz?de?Mandojana and Bansal 2016). The best and the effective optimal framework is known to be with the lowest amount of cost of the debts of financing that is borrowed, which indicates that an organization makes borrowing at the point of time when the rates of interest is low. This will make sure that the value that is payable to the lenders will be as low as possible and therefore the maximum benefits from the debt can be attained.   

It is seen that all the items that are posted in the right hand side of the balance sheet exclusive of the current liabilities is known to the capital sources. The capital has been segmented into equity and debt capital and each one of them has been discussed as follows:

Equity capital is looked upon to be the ownership capital of an organization. It is known to be the capital that is permanent in nature and therefore cannot be withdrawn within the entire life of the organization. The entrepreneurs are the actual bearers of the risk but they even enjoy various kinds of rewards (Dietz et al. 2016). The liability is limited to the amount of capital that is contributed. The equity shares are renowned among the class of investing.

Banker, Mashruwala and Tripathy (2014) explained that capital comprises of two kinds and they are contributed capital which has been Contributed capital which is known to be the money that has been invested originally in the company in exchange for the stock shares and the retained earnings, which represents the profit for the previous years that have been preserved by the organizations and utilised in order to fortify the balance sheet or the development of the fund and the acquisitions and expansion.

The debt capital in a capital structure of a firm is known to the money that is borrowed, which is operational in the business. The most safest kind is usually comprises of the long term debt as the organization has their years in order to come up with the principal and thereafter coming to the payment of the interest but Baker (2015) addressed that debenture capital  is a section of the borrowed capital. There are various kinds of debentures that are issued for the suitability of the investors. The companies can even attain medium and long term loans from the banks and the financial organizations (Sydler, Haefliger and Pruksa 2014). The public deposit can be utilised as a debt finance as it is seen that public deposit is known to be the money that is received by the companies that are non-banking in nature by the process of depositing the loan from the public, which is inclusive of the shareholders, employees and the customers of an organization other than being in the form of debentures and shares.

When an organization decides to make use of the process of debt financing for their activities, it is seen that they are faced with the financial risk and it is known to be a company that is levered. Cohen and Kietzmann (2014) explained financial risk to be an additional risk that is placed on the general stakeholders as an outcome of the decisions related to finance with debt. Financial risk is known to be the probability that the income of the company will not be forecasted due to the process of financing.

The research methodology is related to having an understanding of the kind of data and information that would be used by the researcher in order to undertake the entire data analysis process. The researcher has the option of selecting the ideal data in accordance to the topic with the help of which relevant analysis can be done with the help of which desired outcome can be attained (França et al. 2017). The methodology even determines the process that would be used and the analysis tool that would be used for the same purpose.

The researcher in order to collect data in accordance to the research has chosen realism philosophy due to the fact that realism philosophy is ideal for quantitative and qualitative data analysis (Choy 2014). This philosophy is helpful in making use of the ideology that would be appropriate for the completion of the paper. The researcher in relation to this topic has chosen deductive approach mainly due to the fact that the researcher not opted to prepare and construct new and innovative theory and model but has decided to utilise the models and the theories that have been constructed by the other researchers at any previous time period (Lewis 2015). This is due to the fact that the topic that has been considered is not in need of a new theory and would suffice with the use of deductive approach.

The researcher in the current research has selected descriptive research design simply due to the fact that the entire aspects would be explained in an explicit manner with the help of which better results can be attained (Vaioleti 2016). The explanation of all the variables would be helpful in the development of the idea and the attributes with the help of which better and efficient results can be attained (Bauer 2014). The use of these theories would be helpful in determining the relationship between capital structure and financial sustainability of an organization.

The researcher in this paper has made use of primary and secondary data with the help of which precise idea can be attained that would be helpful in answering the issues that is associated with the topic. The researcher would make use of various kinds of tools and methods that would be useful for answering the topic and reaching the conclusion for the paper.  The time frame that would be used for the completion of the entire paper would be provided in order to create an idea about the completion of the entire paper.

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