FINANCIAL STRUCTURE: CHARACTERISTICS, CLASSIFICATION AND EXAMPLE - DUDAS - 2024

The financial structure is the combination of short-term liabilities, short-term debt, long-term debt, and capital that a company uses to finance its assets and operations. The composition of the financial structure directly affects the risk and value of the associated business.

The financial manager must decide how much money to borrow, obtain the best mix of debt and equity, and find less expensive sources of funds. As with the capital structure, the financial structure divides the amount of the company's cash flow to creditors and the amount allocated to shareholders.

Each company has a different combination, depending on their expenses and needs; therefore, each business has its own particular debt-to-equity ratio. It may be the case that an organization issues bonds to use the income obtained to buy shares or, conversely, that issues shares and use these profits to pay its debt.

characteristics

Financial structure refers to the art of designing the mix of funds that will be used to finance a business, especially with regard to the amount of debt to be raised and with what repayment profile.

Includes analysis and decisions regarding debt instruments, when more than one is available.

Relying significantly on funds for debt allows shareholders to obtain a higher return on investment, as there is less capital in the business. However, this financial structure can be risky, as the company has a large debt that must be paid.

A company positioned as an oligopoly or monopoly is better able to support a leveraged financial structure, as its sales, profits, and cash flow can be reliably predicted.

Conversely, a company positioned in a highly competitive market cannot withstand a high degree of leverage as it experiences volatile earnings and cash flows that could cause it to miss debt payments and trigger bankruptcy.

A company in the latter position needs to take its financial structure to the direction of more capital, for which there is no repayment requirement.

Financial structure vs. capital structure

A financial structure includes long and short term obligations in its calculation. In this sense, the capital structure can be seen as a subset of the financial structure, being more oriented to long-term analysis.

The financial structure reflects the status of working capital and cash flow, wages payable, accounts payable, and taxes payable. Therefore, it provides more reliable information regarding current business circumstances.

Factors to consider

Leverage

Leverage can be positive or negative. A modest increase in earnings before tax will give a large increase to earnings per share, but at the same time increase financial risk.

Cost of capital

The financial structure should focus on lowering the cost of capital. Debt and preferred equity capital are cheaper sources of financing compared to equity.

Control

The financial structure should consider that the risk of loss or dilution of control of the company is low.

Flexibility

No company can survive if it has a rigid financial composition. Therefore, the financial structure must be such that, when the business environment changes, the structure must also adjust to cope with expected or unexpected changes.

Solvency

The financial structure must be formed in such a way that there is no risk of an insolvency of the company.

Classification

The financial structure describes the origin of all the funds that a company uses to acquire assets and pay expenses. There are only two types of sources for all those funds.

Debt financing

Companies acquire funds through debt financing, mainly from bank loans and the sale of bonds. These appear on the balance sheet as long-term liabilities.

Especially note that the company's debt (balance sheet liabilities) also includes short-term obligations, such as accounts payable, short-term promissory notes, wages payable, and taxes payable.

Owners actions

These are those that the company owns in its entirety, appearing on the balance sheet as "shareholders' shares." In turn, the actions come from two sources:

- Paid capital: these are payments that the company receives for the shares that investors buy directly from the company when it issues shares.

- Retained earnings: these are the earnings after taxes that the company maintains after paying dividends to shareholders.

These two sources taken together are a complete side of the balance sheet. Entrepreneurs interested in the financial structure of the company will compare the percentages of each source with respect to the total financing.

The relative interest rates will define the financial leverage of the company. These determine how owners and creditors share the risks and rewards given by the performance of the business.

Differences in financial structures

A small business is more likely to consider traditional financing models. The possibility of receiving private investments or issuing securities may not be available to you.

Companies in sectors that depend more on human capital may prefer to finance their operations by issuing bonds or other securities. This may allow them to obtain a more favorable rate, as the option to guarantee with assets may be very limited.

Larger companies, regardless of their industry, are more inclined to consider offering bonds or other securities, especially when the companies already have shares traded on a public market.

Example

The image below shows how capital and financial structures appear on a company's balance sheet.

Balance sheet item groups define three structures for the company: the asset structure, the financial structure, and the capital structure.

The financial structure of the company is shown on the entire equity and liabilities side, and the capital structure is a section of the financial structure.

The financial and capital structures show how the investor owners share the risks and rewards of the company's performance. As a result, these structures describe leverage.

References

1. Investopedia (2018). Financial Structure. Taken from: investopedia.com.
2. Solution Matrix (2018). Financial Structure, Capital Structure Capitalization, Leverage. Taken from: business-case-analysis.com.
3. Steven Bragg (2018). Financial structure. Accounting Tools. Taken from: accountingtools.com.
4. Surbhi (2015). Difference Between Capital Structure and Financial Structure. Key Differences. Taken from: keydifferences.com.
5. Leonardo Gambacorta (2014). Financial structure and growth. Taken from: bis.org.