Business
activities are directly affected by the acquisition and
utilization of finances. The financing function is at the nerve
of all managerial functions in any business. Production, marketing,
recruitment, distribution,
acquisition of capital goods and advertising are functions that depend on availability of finance
For
production to occur, a company must hire. But this is not
be possible if the company has no money to pay salaries. Likewise,
products must be marketed then channeled to end users. But in the
absence of finances such products would remain in a warehouse and
consumer needs would not be met.
When
a company is experiencing financial difficulties or is unable to
raise enough finances to continue operating, focus should shift to the
finance department's ability to raise the necessary funds and meet the shortfall.
If a company is to continue performing the functions of production, marketing and distribution, then it can only do so within the confines of the financial constraints. This means that the strategies it adopts will be inflexible and entirely dependent on its financial limitations.
If a company is to continue performing the functions of production, marketing and distribution, then it can only do so within the confines of the financial constraints. This means that the strategies it adopts will be inflexible and entirely dependent on its financial limitations.
The
capital structure of a company relies on the financing strategy that a
company adopts while raising funds. A company can raise money
from its owners (equity funds) or borrow
from a milliard of sources (debt). It can also choose to employ a
combination of these two methods in varying proportions. In essence
therefore, capital structure is simply how the company combines debt and
equity
to raise required funds for operations.
Managers
must consider many factors when deciding whether to use debt or
equity to finance operations. However, in doing so they ought to have
the best interest of the company's owners in mind. Owners simply
want to see the value of their ownership growing. For this reason the
best mode of financing must be the one that maximizes their wealth.
Each of the two methods has its own merits and demerits and so managers must determine the best mix that will minimize risk and maximize
the value of the shareholders’ ownership.
Debt must be repaid. Those who advance credit to a company expect to
earn interest on their funds. Revenues from the company’s
operations will be used to repay the borrowed funds. Therefore the funds
available, for other functions that the company might want to carry out, will
be reduced in relation to the interest paid.
Debt also comes with conditions. The management looses control in
decision making due to the conditions attached. For instance a financial
institution might require the company borrowing from it to halt any
more recruitment of staff in order to cut costs and to offer an assurance that it
will be able to re-pay the money when it falls due. Of course, this might hinder
the management’s plan of increasing production.
On the other hand, a company is under no obligation to repay equity funds. This mode of
financing is less risky. When a
company decides not to pay dividends to its shareholders and instead retains earnings to finance operations, it is simply using equity
funds to avoid or minimize debt.
Equity funds are not tax deductible. A company’s tax obligation is
hence directly proportional to the amount of equity funds available. Taxes reduce the amount of funds at the
company’s disposal.
Both equity and debt are obtainable at a cost, namely the cost of equity
(rate of return on invested funds) and interest on debt. The company must also
incur transaction costs and bear with the burden of institutional restrictions
and corporate taxes. These factors affect the operations of a company in
different ways and the management must make corporate decisions in view of
these conditions.