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The Secret of Financial Leverage: How to Make Your Company Win More?
In corporate financial management, capital structure is one of the key factors affecting corporate development and sustainability. The concept of capital structure encompasses the various sources of external funding used by a company to operate and expand, including stockholders' equity, debt, and preferred stock. An effective capital structure not only promotes company profitability but also balances risk and reward.
The capital structure is determined by the ratio of debt. An excessive debt ratio will increase the risk of the company and affect its financial flexibility.
Basic concept of leverage effect
The leverage effect is when a company borrows funds to increase its future profitability. When a business uses debt for financing in moderation, it can significantly enhance earnings per share. That's because the interest a company pays on debt is usually tax-deductible, reducing the tax burden and allowing more operating income to ultimately flow into investors' pockets. However, if the company's operating conditions are not good, excessive debt will increase the risk of bankruptcy and affect the company's long-term stability.
Optimal capital structure
A company's financial management must recognize the risks posed by debt and maintain an appropriate balance between debt and equity. The optimal capital structure is one that maximizes the value of the company while minimizing the cost of capital. When deciding what capital structure to use, corporate management needs to consider how it can attract new external funding and maintain a good credit rating.
Management selections should be based on outside audiences' perceptions of the business's financial health.
The timing of capital structure
Once a reasonable debt level is determined, the proportion of short-term debt to long-term debt needs to be considered. Adding short-term debt increases a business's financial flexibility because borrowers have a shorter commitment to interest. However, this also imposes greater refinancing risks on the business. According to a 2022 article in the Journal of Finance, an increase in short-term debt ratios will increase investors' return requirements on equity.
Disorganized capital structure and bankruptcy liquidation
Prioritizing your capital structure is particularly important in bankruptcy situations. Generally speaking, the priority order is: senior debt, subordinated debt, preferred stock and common stock. In capital structure design, good understanding and planning will enhance the company's solvency.
Agency costs and capital structure
The existence of agency costs complicates the correlation of capital structure. As the debt ratio increases, management often has an incentive to make riskier investments, which can lead to adverse business decisions. Therefore, increasing leverage can protect shareholder interests by promoting monitoring of management behavior and increasing financial discipline.
Capital structure and macroeconomic conditions
In addition to the company's own situation, macroeconomic conditions also have an important impact on the choice of capital structure. Research shows that the specific choices of corporate financing will be affected by the market environment, which makes capital structure choices show different patterns under different economic cycles. As economic conditions improve, many companies tend to issue debt to look for opportunities to add value, while in times of adversity they tend to rely on equity financing to reduce risk.
Persistence of capital structure
The lack and excess of corporate leverage factors have shown considerable persistence over a long period of time. This means that the design of a company's capital structure remains stable despite changes over time. "
Good capital structure decisions are crucial to a company's future growth.
From this point of view, are your strategic design of capital structure for your company comprehensive and rigorous enough?
