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What Are the Determinants of Capital Structure?

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  • Written By: Kenneth W. Michael Wills
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 03 September 2016
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Any type of organization or entity, whether a corporation or a nation, relies on capital to facilitate its operations and achieve it core functions. How the organization structures its capital will often determine the efficiency in which it is able to leverage that capital to accomplish its goals. Capital structure in an organization thus refers to the ratio of both debt and equity that comprise those capital resources. Central to analyzing capital structure is the ratio of long-term to short-term debt, in addition to debt-equity ratios. Determinants of capital structure are dependent upon these ratios with the main factors being organizational size, cost of fixed assets, organizational purpose or focus, legal requirements, organizational control, investment requirements, reasons for obtaining finance, terms of finance, market conditions, and flexibility required as well as requirements of investors or others who have a stake in organizational outcomes.

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Most organizations will seek a balance in capital structure that effectively addresses organizational needs, while allowing all capital, both debt and equity to work productively. Some researchers refer to this as an “ideal” capital structure. Crucial to achieving this ideal structure of capital is to understand those determinants most specific to the organization. Aligning those determinants with the right mix of debt and equity financing helps ensure consistent cash flow, profitability, and required flexibility in deploying capital resources. Examination of capital structure in both nations around the world, as well as businesses of all types, has concluded the aforementioned determinants of capital structure are central to nearly all organization entities.

Fixed assets are important to analyzing capital structure, because without those assets an organization cannot function, which defines their permanency, rather than alludes to their value, which fluctuates. Size of an organization is also crucial, wherein most cases larger capital resources are required of larger organizations or nations. Overall mission and goals of the organization will also determine both sources of capital and how that capital is sourced. Structure of bureaucracy, management and control also influence how capital is structured to protect overall integrity of the organization and its administration. Each of these determinants of capital structure are most often directly under the control of the organization or firm and even can be adjusted to reflect access to capital.

On the other hand, other determinants of capital structure usually require a more analytical approach to ensure an understanding of their potential impact on the organization. Legal requirements will often determine what types of capital an organization can access, such as parliament of a nation applying a ceiling to the amount of debt a nation can hold. Potential finance arrangements and consideration of tapping into equity are usually assessed to determine their impacts in both the short-term and the long-term. Market conditions and investor or stakeholder requirements also have to be analyzed to assess impact on utilizing various types of investments to meet organizational goals. Each of these determinants of capital structure are taken into consideration on a continual basis, with capital structure being revised when required to align organization goals with required accessible capital resources.

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