Capital management is the process of monitoring and controlling changes in a company's financial structure. Companies make capital investments to improve their operations for expansion or other purposes (Saxo wealth care). These require capital, which can be sourced from internal cash flow, long-term loans, short-term borrowings or equity financing.
All the investments made come with an associated cost known as interest expense. This interest cost needs to be compared with the expected return on such investments (known as Return On Capital Employed ) to determine whether it is relevant for a business to make such investments in the first place.
If it does not yield good returns on capital employed then there is no point in having more debt than necessary. It also helps businesses comply with financial covenants specified in loan contracts.
Ensure financial flexibility
The management of capital costs helps ensure financial flexibility to respond to any opportunities or challenges as they arise. In case there are excess funds available with a business, this is known as free cash flow, which can be reinvested into profitable ventures, distributed among shareholders in the form of dividends, retained for investment purposes or used to reduce debt.
Capital structures usually consist of three main components: Debt, Equity and Hybrid instruments. When a company raises capital from external parties by issuing shares, these shares are classified as equity.
Any borrowings by a firm will constitute debt. A company may issue various hybrid instruments such as convertible debentures to augment its funding options. These Hybrid instruments usually have both debt and equity characteristics - they are a combination of loan and share instruments.
The capital employed by a company is divided between debt, equity and hybrid instruments. The financial types ratio of the three components of capital used by a company is known as its capital structure. A strong capital structure ensures that there is enough money coming from internal sources to meet the outflow of funds. Companies with a low debt to equity ratio often have a better credit rating since it helps reduce the risk for lenders who offer loans on good terms.
When companies have excess cash but cannot invest in new projects due to a lack of opportunities or regulatory restrictions on investment, these funds may be retained in current accounts as working capital.
Alternatively, some companies deploy excess funds through capital management activities - buying back their shares, paying down debt, or issuing bonus shares are more popular capital management methods.
Increase shareholder value
These activities are undertaken to increase shareholder value. By reducing the number of outstanding shares in a company, the proportionate equity interest held by each shareholder increases. It automatically improves metrics such as earnings per share and returns on equity, which directly influence the market price of shares.
Companies can also choose to issue additional shares during tough times when investors have little appetite for new issues, known as follow-on public offer (FPO). Issuing FPOs helps improve short-term financial flexibility since they are usually at cheaper valuations due to high demand for shares.
Helps reduce tax liability
Finally, many companies choose to enter into capital leases since it helps reduce tax liability. In a capital lease agreement, ownership of an asset is transferred from the lessor (original owner) to the lessee (borrower).
However, in the case of a financial lease, the original owner retains ownership of an asset during the entire lease period. This arrangement often results in lower monthly payments against interest expense on borrowings since these costs are paid on a reducing balance basis while making total leases.
The entities that borrow money and issue some form of the debt instrument as security are debenture holders. Different kinds of debt instruments are categorized according to their priority when liquidated; these include secured instruments like mortgages, which take precedence over unsecured instruments like debentures.
The market for debt instruments is relatively liquid and ranges from treasury bills to commercial papers to convertible bonds, depending on each issuer's risk perception.