Capital Structure Objectives (AQA A-Level Business): Revision Notes

Capital Structure Objectives

What is capital structure?

A business's capital structure describes how it finances its long-term operations and growth. It consists of two main components that together form the long-term capital (finance) of the business.

Long-term capital is made up of:

• Equity (share capital) – money raised by selling shares to investors
• Borrowing (loan capital) – money raised through bank loans and other forms of debt

Why capital structure matters

The proportion of borrowing to equity represents an important strategic decision for any business. This balance has significant implications for financial health and risk management.

Higher levels of borrowing mean the business faces greater interest repayment obligations. This creates financial risk, particularly if profits decline for any reason. When a business relies heavily on loans, it must make regular interest payments regardless of its financial performance.

A business may therefore establish targets relating to the proportion of long-term capital that comes from debt rather than equity. These targets help manage financial risk and maintain a sustainable capital structure.

Measuring capital structure: the gearing ratio

The gearing ratio measures the proportion of a business's long-term capital that comes from borrowing. It provides a clear indication of financial risk and is a key metric for assessing capital structure objectives.

The gearing ratio formula

The gearing ratio is calculated as follows:

$\text{gearing ratio} = \left(\frac{\text{loan capital}}{\text{total capital}}\right) \times 100$

Where:

$\text{total capital} = \text{loan capital} + \text{equity}$

This produces a percentage showing what proportion of long-term finance comes from debt.

Interpreting gearing ratios

• High gearing (typically above 50%) indicates the business relies heavily on borrowing. This creates greater financial risk due to substantial interest obligations.

• Low gearing (typically below 50%) suggests the business uses more equity finance. This generally represents a safer financial position with lower interest burdens.

Business vulnerability and gearing

Businesses selling luxury items may be particularly affected by changes in interest rates when gearing is high. Rising interest rates increase costs significantly for highly geared businesses. This can force price increases, potentially reducing demand for premium products.

Setting capital structure objectives

When establishing capital structure objectives, businesses typically consider several key factors to balance risk and opportunity.

Target gearing ratio – Businesses often set an upper limit on the proportion of debt finance to maintain financial stability. This prevents over-reliance on borrowing and reduces vulnerability to interest rate changes.

Interest coverage – Objectives should ensure profits are sufficient to cover interest payments comfortably, even during difficult trading periods.

Flexibility – Maintaining the ability to raise additional funds when needed, whether through equity or borrowing, provides strategic options for growth and development.

These objectives must align with the business's overall strategic goals and the economic environment in which it operates. Different industries and business models may have different optimal capital structures.