Financial Structure

Financial Structure

There are persistent differences across industries in the financial structure of the liabilities side of their balance sheets. Understanding these differences and why they persist is a central, and as yet unresolved, issue in financial economics. If there is an optimal capital structure for a company it will minimize the opportunity cost of capital and maximize shareholders’ wealth. Debt is a two edged swords- it increases shareholder returns when the firm has high operating income, but makes them worse than they otherwise would be when the firm has low operating income.

Key chapter concepts

·         Financial structure refers to the way the firm’s assets are financed. Financial structure is represented by the entire right hand side (in USA) and left hand side (in Nepal) of the balance sheet. It includes short term debt and long term debt as well as shareholders’ equity.

·         Capital structure or the capitalization of the firm is the permanent financing represented by long-term debt, preferred stock and shareholders’ equity. Thus a firm’s capital structure is only a part of its financial structure.

·         The optimal capital structure occurs at the point at which the overall cost of capital is minimized and firm value is maximized.

·         Leverage involves the use of fixed operating costs (depreciation, salaries, rent etc.) and fixed capital costs (interest, preferred stock dividend) by a firm.

·         The use of operating fixed cost creates operating leverage and this shows the relationship between sales and EBIT. The degree of relationship is measured by degree of operating leverage (DOL).

o        The degree of operating leverage (DOL) is defined as the percentage charge in EBIT resulting from 1 percent change in sales.

o        DOL also indicates the business risk and all other things being equal the higher a firm’s DOL, the greater is its business risk.

o        The degree of operating leverage approaches towards maximum as the firm comes closer to operating at its breakeven level of output.

·         The use of financial fixed cost creates financial leverage and this shows the relationship between EBIT and EPS. The degree of relationship is measured by degree of financial leverage(DFL)

o        Degree financial leverage is defined as the percentage change in earnings per share (EPS) resulting from 1 percent change in EBIT.

o        The degree of financial leverage approaches a maximum as the firm comes closer to operating at its loss level, the level were EPS = $0.

o        The DFL also measure the financial risk of a firm. All other things being equal the higher a firms DFL, the greater is its financial risk.

o        Financial risk, the additional variability of a firm’s EPS that results from the financial leverage, can also be measured by various financial ratios, such as the debt to total assets ratio and the times interest earned ratio.

·         The combined (total) leverage creates due to the use of total fixed cost and this leverage shows the relationship between sales and EPS. The degree of relationship is measured by degree of combined leverage (DCL).

o        The degree of combined leverage (DCL) is defined as the percentage change in earning per share resulting from a 1 percent change in sales. It is equal to the DOL for a company times that company’s DFL. The degree of combined leverage used by a firm is a measure of the overall variability of EPS due to the use of fixed operating and capital costs, as sales levels change.

·         EBIT-EPS analysis is an analytical technique that can be used to help determine the circumstances under which a firm should employ financial leverage.

·         The indifference point in EBIT-EPS analysis is that level of EBIT where earnings per share are equal at two different alternative of financing alternatives.