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FAJILAGO,RIA
PLANNING THE FINANCIAL
STRUCTURE
ASSOC. PROF. RIA SANTOS FAJILAGO
DEPARTMENT OF BANKING AND FINANCE
COLLEGE OF ACCOUNTANCY AND FINANCE
POLYTECHNIC UNIVERSITY OF THE PHILIPPINES
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Introduction
Funds are the basic need of every firm to fulfill long-term and working capital requirement.
Some covers only the long-term sources of funds while others imply the way assets of the
company are financed that represents the whole liabilities side of the balance sheet statement
which includes both long-term and current liabilities.
FAJILAGO,RIA
Property, Plant & 9,716
Equip 1,222
Intangible Assets 68
LIABILITIES
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Current Liabilities 3,464
Long-Term
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The Three Structures
Groups of Balance sheet items define three structures for the firm:
a. Asset structure.
b. Financial structure.
c. Capital structure (Capitalization).
For the analyst, describing and evaluating each structure is mostly a matter of comparing the
relative magnitudes of items within the structure.
• Financial and capital structures show how investor owners and lenders share risks and rewards
of company performance. As a result, these structures describe leverage.
• Asset structure shows how the firm chooses to maximize return on assets (ROA).
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FINANCIAL STRUCTURE DEFINED
Financial Structure refers to the mix of debt and equity that a company
uses to finance its operations.
This composition directly affects the risk and value of the associated
business. The financial managers of the business have the responsibility of
deciding the best mixture of debt and equity for optimizing the financial
structure.
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Capital Structure vs. Financial Structure
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Financial Structure
The mix of long-term and short-term funds employed by the company to procure the assets
which are required for day to day business activities is known as Financial Structure. Trend
Analysis and Ratio Analysis are the two tools used to analyze the financial structure of the
company.
The composition of the financial structure represents the whole equity and liabilities side of the
Balance Sheet, i.e. it includes equity capital, preference capital, retained earnings, debentures,
short-term borrowings, account payable, deposits provisions, etc.
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Factors in designing the Financial Structure
a. Leverage- Leverage can be both positive or negative, i.e. a modest rise in the EBIT will give a
high rise to the EPS but simultaneously it increases the financial risk.
b. Cost of Capital- The financial structure should focus on decreasing the cost of capital. Debt and
preference share capital are cheaper sources of finance as compared to equity share capital.
c. Control- The risk of loss and dilution of control of the company should be low.
d. Flexibility- Any firm cannot survive if it has a rigid financial composition. So the financial structure
should be such that when the business environment changes structure should also be adjusted to
cope up with the expected or unexpected changes.
e. Solvency- The financial structure should be such that there should be no risk of getting insolvent.
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Capital Structure
The combination of long-term sources of funds, i.e. equity capital, preference capital, retained earnings and
debentures in the firm’s capital is known as Capital Structure.
It focuses on choosing such a proposal which will minimize the cost of capital and maximize the earnings per
share. For this purpose a company can opt for the following capital structure mix:
a. the pattern opted for capital structure should reduce the cost of capital and increase the returns
b. the capital structure mix should contain more of equity capital and less of debt to avoid the
financial risk
c. it should provide liberty to the business and management to adapt itself according to the
changes and so on.
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Differences Between Capital Structure & Financial
Structure
1. The capital composition of the company which includes only long-term funds raised is known as
Capital Structure. The combination of long term and short term funds utilized by the company for
acquiring resources is known as the financial structure.
2. Capital Structure appears under the head Shareholders Fund and Non-current liabilities. Conversely,
the entire equity and liabilities side shows the financial structure of the company.
4. Capital Structure includes equity capital, preference capital, retained earnings, debentures, long-
term borrowings, etc. On the other hand, Financial Structure includes shareholder’s fund, current and
non-current liabilities of the company.
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Remember
Capital Structure and Financial Structure are not contradictory to each other. Instead, they are
inseparable.
The optimum capital structure is when the company uses a mix of equity and debt financing that
the value of the firm is maximized and side by side the cost of capital is also minimized.
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DEBT VS. EQUITY
Financial Structure refers to the mix of debt and equity that a company
uses to finance its operations.
This composition directly affects the risk and value of the associated
business. The financial managers of the business have the responsibility of
deciding the best mixture of debt and equity for optimizing the financial
structure.
Debt financing- Firms acquire funds through debt financing, primarily from bank loans and the sale
of bonds.
Note especially that the company's debt (Balance sheet liabilities) also includes near-term
obligations such as short-term notes payable, accounts payable, salaries payable, and taxes
payable.
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Sources of Financial Structure
Owners equities- These are what the company owns outright, appearing on the Balance sheet
under "Equities" (or "Stockholders Equities"). And, equities, in turn, come from two sources:
a. Paid in Capital- These are payments the firm receives for stock shares investors purchase
b. Retained Earnings- Retained earnings are after-tax profits (earnings) the company keeps after
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Defining and Measuring Financial Leverage
One primary measure of the balance between funding sources is a leverage metric, the "Total
debt to equities ratio."
This metric is sometimes called simply the "Debt to equities ratio," or even more simply the "Debt
ratio." Analysts interpret this metric as a measure of financial leverage, or "Trading on equity."
Note that a similar but different leverage metric, the "Long-term debt to equities ratio" appears
in the section below on calculating capital leverage.
Some textbooks symbolize this ratio as B / V, where B is the company's total debt, and V is
company value or total equities. And, some prefer to symbolize the same ratio as D/E, where D
is the total debt and E is total equities.
FAJILAGO,RIA
Property, Plant & 9,716
Equip 1,222
Intangible Assets 68
BALANCE SHEET, In Thousands Other Assets
Asset Structure
Total Assets
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22,075
LIABILITIES
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Current Liabilities 3,464
Long-Term
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Calculating the Total Debt to Equities Ratio
(Financial Leverage)
= P 8,938,000 / P13,137,000
= 0.68
Increasing debt funding has two results. 1. the debt to equities ratio increases, 2. the firm's financial
structure leverage increases.
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Defining, Explaining, Measuring Capital Structure
Capital structure describes the sources of funds a company uses for acquiring income-producing
assets. The focus of these funds contrasts with the financial structure concept which includes all of
the company's debt and equities.
Capital structure considers only the firm's long-term liabilities. Capital structure items lie on the
"Liabilities + Equities" side of the Balance sheet but exclude Current Liabilities.
Those interested in a firm's capital structure will compare the percentages of total funding for
income-producing assets that comes from each source. They want to know, that is, whether
capital funding is primarily equity funding or debt funding.
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Defining and Measuring Capital Leverage
One measure of the balance between capital funding sources is another leverage metric, the
Long-term debt to equities ratio.
Note that this ratio is very similar to the financial leverage metric.
However, this ratio, using only long-term debt, serves to measure the firm's capital leverage.
FAJILAGO,RIA
Property, Plant & 9,716
Equip 1,222
Intangible Assets 68
BALANCE SHEET, In Thousands Other Assets
Asset Structure
Total Assets
22
22,075
LIABILITIES
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Current Liabilities 3,464
Long-Term
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Calculating the Long-Term Debt to Equities Ratio
(Capital Leverage)
Like the other metric, above, based on total debt, the Long-term debt to equities ratio derives from entries on the firm's
Balance sheet.
The greater the debt funding component (the higher the long-term debt to equities ratio), the higher the degree of
leverage in the company's capital structure.
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Conclusion
Note that RSF Corporation's "capital leverage" (0.42) is lower than its "financial leverage" (0.68).
"Financial leverage" will, in fact, always be higher than "Capital leverage," except in the
improbable case that the firm has no short-term debt.
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Leverage Defined
Leverage is the use of debt by a company to fund its operations and expansion projects in an
effort to generate a return for shareholders.
Companies that aggressively use debt financing are considered highly leveraged and typically
risky to invest in.
Leverage is the use of borrowed funds aimed at generating a return on equity for investors.
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OPERATING VS FINANCIAL LEVERAGE
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Operating Leverage vs. Financial Leverage
Leverage is a firm’s ability to employ new asset or funds to create better
returns or to reduce costs.
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Basis for Comparison Operating Leverage Financial Leverage
2. What it’s all about? It’s about the fixed costs of the firm. It’s about the capital structure of the firm.
Operating leverage measures the operating risk Financial leverage measures the
3. Measurement
of a business. financial risk of a business.
7. How much it is preferred? The preference is lower. The preference is much higher.
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Leverage Benefits and Risks
A high degree of leverage has several implications for owners and creditors.
a. if and only if business performance is healthy (as in a good economy), the following holds: High
leverage provides owners with higher profitability and a higher return on investment (or return on
equity) than low "leverage.“
b. when a business is doing poorly, leverage gives owners lower profits and lower return on equity,
than when it is higher.
c. the higher the degree of leverage the higher the potential rewards and also the higher the
potential loss for owners.
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Business Risk
One consequence of high leverage is an increase in business risk. Here, the term refers to the risk of
low earnings. Analysts typically define business risk for a firm as follows:
Where:
"Before-tax earnings from assets" = EBIT (earnings before interest and taxes)
When leverage is high, business risk is high. And, when business risk is high, the range of possible EBIT
results is extensive. And, with low business risk, potential EBIT results cover a much narrower range.
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Financial Risk
Analysts also take an interest in a second risk factor that accompanies high leverage. Financial risk
refers to the possibility that a firm might not be able to meet its financial obligations. Not surprisingly,
the financial risk rises with rising debt level. And, this means that "financial risk" increases as
leverage increases.
Note that from its EBIT, a firm must first pay interest due on loans, bonds, and service other debt,
before paying shareholder dividends or retaining earnings. With higher leverage, the firm has more
debt service to pay. When profits are low, therefore, the firm with high "leverage" risks being unable
to meet its financial obligations. Not surprisingly, when a company has a high financial risk, its credit
ratings and bond ratings suffer.
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Gearing Ratios for Leverage Metrics
In business, owners and their relatively smaller equity gain leverage to bring in more substantial
earnings by using relatively more debt financing.
1. Total debt to equity ratio, where B = total debt and V = "Value," or Total Equity.
2. Total debt to total assets, (total debt / total assets). This ratio appears in textbooks as B/TA,
where B = total debt and TA = total assets.
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Leverage Metrics
Leverage metrics show how a firm's owners and creditors share business risks and rewards.
Leverage metrics compare funds creditors supply to the firm to funds that owners supply.
Owners and creditors alike have a keen interest in these metrics because they share business risks and
rewards in proportion to their share of the funding.
Financial leverage is a tactic by which individuals and companies increase their earning power through
borrowing.
Investors and owners use financial leverage to amplify their earning power by borrowing funds that
increase their investment stake. In other words, businesspeople use leverage when they expect to earn
more from the funds they borrow, than the cost of borrowing.
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Degree of Operating Leverage
The operating leverage formula is calculated by multiplying the quantity by the difference between the price and the
variable cost per unit divided by the product of quantity multiplied by the difference between the price and the variable
cost per unit minus fixed operating costs.
DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
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Example
RSF Software is a leading software business, which mostly incurs fixed costs for upfront
development and marketing.
RSF’s fixed costs are P 780,000, which goes towards developers’ salaries and the cost per unit is
P 0.08. The company sells 300,000 units for P 25 each.
Given that the software industry is involved in the development, marketing and sales, it includes
a range of applications, from network systems and operating management tools to customized
software for enterprises.
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Based on the company’s sales, fixed costs, and variable cost per unit,
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its operating leverage is calculated like this:
DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
This means that a 10% increase in sales will yield a 12% increase in profits (10% x 1.12 =.112 or
11.2%)
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Example
If the company increase sales to, let’s say, 450,000 units for P 20 each, the new DOL will be
calculated like this:
This means that a 10% increase in sales will yield an 11% increase in profits (10% x 1.1 =.11 or 11%),
but the company generates P1,527,000 more in sales revenues (8,964,000 -7,437,000 = 1,527,000).
Note that costs remain unchanged and only by lowering the price the company increases its sales
revenues.
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Another Method
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Remember
A high degree of operating leverage provides an indication that the company has a high proportion of fixed
operating costs compared to its variable operating costs. This means that it uses more fixed assets to support
its core business.
It also means that the company can make more money from each additional sale while keeping its fixed
costs intact. So, the company has a high DOL by making fewer sales with high margins. As a result, fixed
assets, such as property, plant, and equipment, acquire a higher value without incurring higher costs. At the
end of the day, the firm’s profit margin can expand with earnings increasing at a faster rate than sales
revenues.
On the other hand, a low DOL suggests that the company has a low proportion of fixed operating costs
compared to its variable operating costs. This means that it uses less fixed assets to support its core business
while sustaining a lower gross margin.
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Degree of Financial Leverage
A degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a
company’s earnings per share (EPS) to fluctuations in its operating income, as a result of changes in
its capital structure. The degree of financial leverage (DFL) measures the percentage change in
EPS for a unit change in operating income, also known as earnings before interest and taxes (EBIT).
This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will
be. Since interest is usually a fixed expense, leverage magnifies returns and EPS. This is good when
operating income is rising, but it can be a problem when operating income is under pressure.
DFL=EBIT/EBIT − Interest
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Example
Assume that RSF Inc. has operating income or earnings before interest and taxes (EBIT) of P100
million in Year 1, with interest expense of P10 million, and has 100 million shares outstanding. EPS for
RSF in Year 1 would thus be:
Operating Income of P100 Million − P10 Million Interest Expense/100 Million Shares Outstanding= P 0.90
This means that for every 1% change in EBIT or operating income, EPS would change by 1.11%.
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Example
Now assume that RSF has a 20% increase in operating income in Year 2. Notably, interest expenses
remain unchanged at P10 million in Year 2 as well.
EPS for RSF in Year 2 would thus be:
Operating Income of P120 Million − P10 Million Interest Expense/100 Million Shares Outstanding=P1.10
In this instance, EPS has increased from 90 cents in Year 1 to P1.10 in Year 2, which represents a change
of 22.2%.
This could also be obtained from the DFL number = 1.11 x 20% (EBIT change) = 22.2%.
If EBIT had decreased instead to P 70 million in Year 2, what would have been the impact on EPS?
EPS would have declined by 33.3% (DFL of 1.11 x -30% change in EBIT).
This can be easily verified since EPS, in this case, would have been 60 cents, which represents a 33.3%
decline.
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Remember
The degree of financial leverage (DFL) is a leverage ratio that measures the sensitivity of a
company’s earnings per share to fluctuations in its operating income, as a result of changes in its
capital structure.
This ratio indicates that the higher the degree of financial leverage, the more volatile earnings will
be.
The use of financial leverage varies greatly by industry and by the business sector.
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Degree of Total Leverage (DTL)
The degree of total leverage equation shows the total leverage of a company.
You can find the DTL either by multiplying the degree of operating leverage and degree of
financial leverage or by dividing the percentage change in earnings per share by the percentage
change in sales -- both produce the same result.
When the result is greater than 1, the company has total leverage.
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Degree of Total Leverage
DOL x DFL
The first way to figure the DTL is by multiplying the DOL by the DFL.
The DOL equals the company's percentage change in earnings before interest and taxes divided
by the company's percentage change in sales, while the DFL equals the percentage change in
earnings per share divided by the percentage change in EBIT.
For example, if the company has a 40 percent increase in EBIT, a 30 percent change in sales and a
50 percent increase in earnings per share, divide 40 by 30 to get 1.333 and 50 by 40 to get 1.25.
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Alternative Finance
Is defined as “financing from external sources other than banks or stock
and bond markets”.
Crowdfunding
Their loan to you might have some aspects of convertible debt to equity.
In addition, it will definitely be more expensive than a traditional
commercial loan. It will be about as expensive as using a credit card. But
these lenders are great alternative to companies that may not be
bankable.
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Alternative Finance
Private Equity
Private Equity firms are funds, and team of individuals manages this fund
that provides debt and equity to businesses.
Usually, the “hold” period for the investment can be anywhere from 3-7
years. The Private Equity (“P.E”) firms bring best practices and find
synergies with other portfolio companies to streamline costs.
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Alternative Finance
Venture capital is where an outside group takes part ownership of the
company in exchange for capital. The percentages of ownership to
capital can be negotiated, and are usually based on a company's
valuation.
In Factoring, a service provider will front you the money on invoices that
have been billed out, which you then pay back once the customer has
settled the bill. The business can keep going while waiting for customers
to pay their outstanding invoice
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Benefits of Alternative Financing
Market credibility. The startup gets to "borrow" some of the goodwill that the strategic partner has built
up.
Infrastructure help. The larger partner likely has a marketing team, IT, finance, HR – all things a startup
could "borrow" or utilize at a favorable rate.
Overall business guidance. It is likely the strategic partner will join your board as part of the investment.
Remember that they have been guiding a much larger and proven successful business in your industry,
so their advice and viewpoint will be helpful and invaluable.
Relatively hands-off. A strategic partner especially still has their own business to run, so they are unlikely
to be very involved in the day-to-day running of the startup. Occasional updates, such as monthly or
quarterly, are sufficient.
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References
1. https://keydifferences.com/difference-between-capital-structure-and-financial-structure.html
2. https://www.business-case-analysis.com/capital-and-financial-structure.html#measuring-
capital-financial-leverage
3. https://www.myaccountingcourse.com/accounting-dictionary/leverage
4. https://www.accountingcoach.com/blog/trading-on-equity-leverage
5. https://www.business-case-analysis.com/leverage.html#leverage-metrics-step1
6. https://www.myaccountingcourse.com/financial-ratios/operating-leverage
7. https://www.investopedia.com/terms/d/dfl.asp
8. https://www.businessnewsdaily.com/1733-small-business-financing-options-.html
9. https://smallbusiness.chron.com/degree-total-leverage-equation-65790.html
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