What is a Accounting for capital structure? Meaning of capital structure

Accounting for capital structure
Introduction
Capital is the life blood of business. Without sufficient capital, no business can run efficiently and effectively. For smooth running of any organization, they need adequate supply and balance flow of capital. Simple, capital refers to the claim of the owners and outsides against the business resources or properties that are held by the company. Capital is the amount which is invested into the business in terms of kind or cash at the start or anytime as requirement of organization. The capital required for the business is invested by the owners. The capital requirement may also be arranged from outsides capital are bank loan, bond form company money lender etc. the combination of different sources of capital is known as capital structures. Optimal capital structures are designed by considering him prospective earning capacity and possible risk factor.
Meaning of capital structure
The capital needed for the establishment and operation of a business is collected from various sources. They can be divided as owners' capital (equity capital) and borrowed or outside capital (debt capital). Owner's capital is raised through the issuance of share and utilization of accumulated earnings. Outsiders' capital is collected through the issuance of debentures and taking loan. The sum of owner's capital and borrowed capital total capital. The total capital. The proportion of owners' capital and borrowed capital is called capital structure. For example, the total capital of a company is Rs. 2, 00,000 which consist of Rs. 150,000 owner's capital (share capital) and Rs.50, 000 borrowed capitals. In terms of percentage, the proportion of share capital is 75% (i.e. 150,000/200,000) and borrowed capital is 25% (i.e. 50,000/200,000) which is knows as capital structures.

In the ways, capital structures refers to the proportion of deferent sources of finance i.e. equity and debt to the total capitalization. A business organization should be able to choose such a capital structures that can maximize the return of shareholders and value of the firm.
Meaning and concept of Leverage
The term 'leverage' is actually adopted from science term logy. 'Lever'. Lever is an instruments used to lift heavy weight by the use of relatively small amount of force. The literal meaning of leverage is the effect of one variable on another variable. In financial accounting, leverage is used to measure the risk i.e. the effect of change in revenue and costs on the shareholders return, if the leverage is high, a small percentage increase in revenue (sales) return too much increase or decrease in the shareholders return/earnings per share. If the leverage is low, the return charges slightly despite a high incarcerate or decrease in the sales.

The capital of a company can be collected from various sources of financing whose costs are different. Sources of capital can be divided into two types i.e. fixed return and variable return sources of capital. Fixed return sources of capital include debentures, bonds, bank loan and preferences share capital, whose return is fixed. A variable return source of included equity share capital which return is variable is fixed. Variable return sources of capital include equity share capital which return is variable because they receive the residual income. The fixed return sources of capital influence the return of variable sources of capital and such effect is known as leverage.

In this way, equity shareholders are the owner of a company and their return is affected by the investing and financing activities of a company. The purchase of fixed assets increases the fixed operating cost. Similarly, the issue of debentures and preference shares increase the fixed financial cost (interest and dividend). Leverage is the mechanism of measuring the possible effect of investing and financing activities on the earning available to shareholders.

Use/significance of leverage
Leverage refers to the use of fixed costs in an attempt to increases the profitability. Leverage affects the level and variability of the firms' after tax earning and hence, the firm's overall risk and return. The study of leverage is significant due to the following reasons.
Measurement of operating risk: operating risk refers of the firm not being able to cover its fixed operating costs. Since leverage depends on fixed operating costs, large fixed operating cost indicates higher degree of operating and thus, higher operating risk of the firm. High operating leverage is good when sales rising but bad when they are failing.
Measurement of financial risk: financial risk refers to the firm not being able to cover its fixed operating costs. Since operating leverage depends on fixed costs, large fixed operating cost indicates higher degree of operating leverage and thus, higher operating risk of the firm. High operating leverage is goods when sales are rising but badly when they are falling.
Managing risk: financial risk refers to the risk of the firm not being able to cover its fixed financial leverage is multiplicative rather than additive. Operating leverage and financial leverage can be combined in a number of difference ways to obtain a securable degree of total leverage and level of total firm risk. High operating risk can be offset with low financial risk and vice-versa. To keep the risk within manageable limits, a firm which has high operating leverage advised to have low financial leverage and vice-versa.
Designing appropriate capital structures mix: to design an appropriate capital structure mix or financial plan, the amount of EBIT under various financial plans, should be related to earning per share. One widely used means of examining the effects of leverage to analyses the relationship between EBIT and earning per share.
Relationship of financial leverage with cost of capital: the financial leverage will affect the firms overall cost of capital. If financial leverage increases, overall cost of capital declines and vice-versa. Components cost of equity is generally higher than the of debt.

 However, using only lower cost debt would not maximum value because using more debt should raise the cost not both debt and equity. To minimize overall cost of capital, proper capital structure should be design.
Effect of financial leverage on stock price: expected stock price first rises with finical leverage, hits a peak at optimum capital structures and them begging to decline. The capital structure that minimizes to overall cost of capital also maximum the firm's stock price and value of the firm.

Increase profitability: leverage is an effort or attempt by which a firm ties to show high result or more benefit by using. Fixed costs assets and fixed return sources of capital. It ensures maximum utilization of capital and fixed assets in order to increase the profitability of a firm. It helps to know the reasons for not having more profit by a company.

Types of Leverage
On the basis of the nature of risk associated with the investing and financing activities of a form, leverage can be classified as 'operating leverage'. Financial leverage' and 'combined leverage.
a.    Operating leverage
Operating leverage may be defined as the firm's ability to use fixed operating costs to magnify the effect of charges in sales on its earning before interest and tax. The relationship between contribution margin and earnings before interest and tax (EBIT) is called degree of operating leverage. It may be defined as the rate of charge in EBIT due to the change in the rate of sales. The form operating with high fixed operating cost has higher degree of leverage. Higher levels of risk are attached to higher degree of leverage. High operating is good when sales are increasing and bad when they are falling.

Operating leverages is used to measure the business risk. Business risk is the firm not being able to cover its fixed operating costs.
b.    Financial leverage
Financial leverage is related with the financing activities of a firm. As already stated, the sources of funds or capital can be categorized into fixed return sources and variable return sources. Fixed return sources and variable return sources. Fixe return sources of capital include bank loan, debentures, bonds and preferences shares etc. which carry a fixed rate of return. Variable return sources of capital include common stock and retained earnings which return is not fixed. The fixed return sources of capital influence the earning of variable returns sources. The effect is known as financial leverage.

 The use of fixed charge capital is known as financial leverage. If there is no fixed charge capital, there is no financial leverage. The proper utilization of fixed charge capital like debentures, bonds, bank loan and preference share capital is measured by financial leverage. The firm having more debt capital and preference share capital in its capital structures has higher degree of financial leverages and greater amount of financial risk.

Financial leverages are used to measure the financial risk. Financial risk refers to the risk of the firm not being able to cover its fixed financial costs.
Financial leverage differs from the operating leverage as shown in the following table:

c.    Combined leverage
The combination of operating and financial leverage is called total leverage. Operating leverage measure operating risk where as financial leverage measure financial risk. Total leverage or measured leverages measure total risk of the business.
Operating leverage is measured by the percentage change in earnings before interest and tax due to percentage chain in sales where as financial leverage is measured by percentage change in earning per share due to percentage change in earnings before interest and tax.

Measurement of leverage
Different types of leverages can be measured on the basis of variable shown in the incomes statement. The relationship between the items of income statement and variable leverage has been presented with the help of following income statement.

                      EPS= earnings available to equity shareholders/ number of equity shares

a.    Measuring operating leverage  or degree of operating leverage (DOL)
Operating leverage measures the percentage change profit with respect to changes in the sales. Therefore operating leverage is determined through the relationship of the firm's sales and its operating profit (Earnings before interest tax). The relationship between contribution margin and EBIT is called degree of operating leverage. It may be defined as the rate of changes in EBIT due to the change in the rate of sales. Degree of operating leverage (DOL) is measured by using any one of the following approaches:

i.    Income statement approach
ii.    Formula approach
iii.    Percentage approach
b.    Measuring financial leverage or degree of financial leverage (DFL)
Degree of financial leverage is the relationship between percentage change in earning per shares and percentage changes in EBIT. It can also be determined by the relationship between EBIT and EBT. It measures the percentage changes in EPS due to percentage change in EBIT.

c.    Measuring combined leverage or degree of combined leverage (DCL)
The combination of operating and financial leverage is called combined or total leverage. Operating leverage measure operating or business risk where as financial leverage measure financial risk. Total leverage or combined leverages measured total risk of the business.

Operating leverage is measure by the percentage change in EBIT. Thus, combined leverages are measured by percentages change in EPS due to percentages change is sales.


Effects of leverage of shareholders return
As mentioned in the concept of leverage, the net income available to shareholders (which can be expressed by earning per share) is affected by the use of alternative sources of financing. But the effect is not identical for all firms. The use of debt can increase the earning per share of a firm and at the same time it may decrease the earning per share of another firm. The possibility of increasing the earning per share depends upon the feature sales and operating income. If the sales and operating profit is expected to increase, the use of debt can increase the earning per share. Otherwise, the use of debt has adverse effect on earnings per share. Therefore, a firm should measure the effect of alternative sources of financial on the earning of shareholder before making the financial decision.
Analysis of alternative financial plan
A firm may have different alternative for collecting the capital to finance its investment projects. Similarly, a firm can choose a single alternative or more than on e alternative under which the fund can be raised in different proportion. For example, following different alternatives may be possible for raising funds.
1.    Equity share capital
2.    Debt capital
3.    Preference share capital
4.    Combination of equity share capital and debt capital in different proportions.
5.    Combinations of equity share capital and preference share capital in different proportions.
6.    Combination of equity share capital and preference shares capital in different proportion.

EBIT-EPS Analysis
Above alternatives are the major possible financial plans. Selection financial plans. Selection of the best financial plan will be made on the basis of earning per share. The financial plan which ensures largest EPs will be selected. EBIT-EPS analysis is a method to study the effect of leverage. It essentially involves the comparison of alternative methods of financial under variable assumption of EBIT.
Indifference point of EBIT
Different financial plans show different level of EPS. A company must choose the financial plan having highest EPS to maximize the return to shareholders. Indifference level of EBIT is that amount of EBIT at which the both financial plans will be equally benefit to the company. At the level of indifference point, the company is in the situation of choosing either the pan because both plans have equal earning per share.

In the level of indifference point, both financial plans give equal amount of EPS. It is the level of EBIT beyond which the benefit of financial leverages begging to operate in respect of EPS. In the other words, if the estimated EBIT is more than indifference point, levered financial plan is more beneficial to the company since it gives more EPS. But, if estimated EBIT is less indifference point, non levered financial plan is suitable since, it result in higher EPS.
a.    Mathematical/ Equation method
Under this method, EPS formulate of two financial set equal and indifference point is calculated by using mathematical formula.
b.    Trial & error/ tabulation method
Under this method indifference level of EPIT is found out by testing the various level of EBIT unit the equal amount of EPS is identified. Testing of several EBIT for indifference point is one of the time consuming task for us. Therefore, actual amount of indifference point is to be calculated first by algebraic method. Then, testing among the following three different EBIT is to be done.
i.    Below the actual amount of indifference point.
ii.    Equal to actual amount of indifference point.
iii.    Above the actual amount of indifference point.
Therefore, one analytical table is prepared at least three differences EBIT level. The table is really a complete and comprehensive the EPS of two financial plans are equal; the respective EBIT will be the indifference point.

Define leverage and list its types.
The term "leverage" may be define as the acquisition and employment of an assets or sources of fund for which the firm has to pay a fixed cost or fixed return. The ability of the firm to utilize such fund efficiently which results in maximization of the shareholder's return is also covered by the term leverage. Leverage also facilities the appropriate selection of sources of funds among the various alternative available.
 There are basically three types of leverage and they are:
a.     Operating leverage
b.    Financial leverage
c.    Combined or total leverage.
What do you mean by operating leverage? How is it calculated?
The leverage associated with the employment of an asset for which a firm has to pay a fixed cost may be teamed as total/operating leverage. Operating leverage occurs due to fixed operating cost. A firm operating with high fixed cost has higher degree of operating leverage where the firm operating with no fixed operating leverage where the firm operating with no fixed operating cost has no operating leverage. If a firm uses more fixed cost, the operating profit will increase more than the increase in sales.

Operating leverage is determined by the relationship between the firms' sales and its operating profit (earnings before interest tax). It measures the percentage change in operating profit because of percentage change is sales. It reflects the sensitively of EBIT to the change in sales as shown below:

DOL= contribution margin/ EBIT
DOL= percentage change in EBIT/ percentage change in sales

Define financial leverages. How is it calculated?
Financial leverage is related to the financing activities of a firm. The sources of funds can be categorized into fixed return sources and variable return sources. Fixed return sources of capital include bank loan, debentures, bonds and preferences shares etc. which carry a fixed rate of return. Variable return sources of capital include common stock sources of capital influences the earning of variable return sources. The and preference share capital in its capital structures has higher degree of financial leverage and greater amount structure has higher degree of financial leverage and greater amount of financial risk.

Degree of financial leverage is the relationship between percentage change in earning per share and percentage change in EBIT. It can also be determined by the relationship between EBIT and EBT. It measures the percentage change in EPS due to percentage in EBIT. DFL
Define combined leverage. How is it's calculated?
The combination of operating and financial leverage is called total leverage. Operating leverage measure operating risk where as financial leverage measure operating risk where as financial leverage measure financial risk.  Total leverage or combined leverage measure total risk of the business.
Operating leverage is measure by the percentage change in EBIT due to percentage change in sales where as financial leverage is measured by percentage change in EPS due to percentage change is EBIT. Thus, combined leverage is measured by percentage change in EPS due to percentage change is sales.

What do you mean by indifference point? Mention its significance.
Different financial plans show difference level of earnings per share (EPS). A company must choose the financial plan having higher EPS to maximize the return to shareholder. Indifference level of EBIT is that amount of EBIT at which the both financial plan will be equally beneficial to the company. At the level of indifference point, the company is in the satiations of choosing either the plan because both plans have equal EPS.

It is the level of EBIT beyond which the benefit of financial leverage begins to operate in respect of EPS. In the other words, if the estimated EBIT is more than indifference point. Leverage financial plan is more benefit to the company since it gives more EPS. But, if the estimated EBIT is less than indifference point, non-leverage financial plan is suitable since, it result in higher EPS.