“Capital Structure, Business Risk & Financial Risk”

Presented by:Ramesh Pant

BBM-18Fourth Semester

Financial Management

Presented to:Dinesh Paudel(Class teacher)

Capital Structure• A company's capital structure refers to the relative

proportions of equity (raising money by selling shares) and debt (raising money by borrowing) which the company uses to finance its activities.

• Capital structure refers to a company’s outstanding debt and equity. It allows a firm to understand what kind of funding the company uses to finance its overall activities and growth. In other words, it shows the proportions of senior debt, subordinated debt and equity (common or preferred) in the funding. The purpose of capital structure is to provide an overview of the level of the company’s risk. As a rule of thumb, the higher the proportion of debt financing a company has, the higher its exposure to risk will be.

Cont…

Capital structure is commonly known as the debt-to-equity ratio.

A company’s capital structure points out how its assets are financed. When a company finances its operations by opening up or increasing capital to an investor (preferred shares, common shares, or retained earnings), it avoids debt risk, thus reducing the potential that it will go bankrupt. Moreover, the owner may choose debt funding and maintain control over the company, increasing returns on the operations.

Cont…

• Debt takes the form of a corporate bond issue, long-term loan, or short-term debt. The latter directly impacts the working capital. Having said that, a company that is 70% debt-financed and 30% equity-financed has a debt-to-equity ratio of 70%; this is the leverage. It is very important for a company to manage its debt and equity financing because a favorable ratio will be attractive to potential investors in the business.

Business Risk

Business risk refers to the chance a business's cash flows are not enough to cover its operating expenses like cost of goods sold, rent and wages. Unlike financial risk, business risk is independent of the amount of debt a business owes. There are two types of business risk: systematic risk and unsystematic risk.

• Uncertainty about future operating income (EBIT), i.e., how well can we predict operating income?

• Note that business risk does not include effect of financial leverage.

Cont…

Probability

EBITE(EBIT)0

Low risk

High risk

What determines business risk?

• Uncertainty about demand (sales).• Uncertainty about output prices.• Uncertainty about costs.• Product, other types of liability.• Competition.

Financial Risk

Financial risk refers to the chance a business's cash flows are not enough to pay creditors and fulfill other financial responsibilities. The level of financial risk, therefore, relates less to the business's operations themselves and more to the amount of debt a business incurs to finance those operations

Cont…

• Financial risk is the additional risk concentrated on common stockholders as a result of financial leverage.– More debt, more financial leverage, more financial risk.– More debt will concentrate business risk on stockholders

because debt holders do not bear business risk (in case of no insolvency).

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Business Risk vs. Financial Risk

Business risk:– Uncertainty about future EBIT– Depends on business factors such as

competition, operating leverage, etc.

Financial risk:– Additional business risk concentrated on

common stockholders when financial leverage is used

Thanks !