Impact of Capital Structure on Financial Performance of UK SMEs

This dissertation analyzes the impact of capital structure and its determinants on the financial performance of UK Small and Medium Enterprises (SMEs). It explores the conceptual framework of capital structure and the various determinants of capital structure in improving financial performance of SMEs.

Dissertation
( Impact of Capital structure and its
determinants on the financial performance
of the UK Small and medium enterprise )

Table of Contents
Introduction......................................................................................................................................3
Overview of the topic..................................................................................................................3
Research aim...............................................................................................................................3
Research objectives.....................................................................................................................3
Research question........................................................................................................................4
Significance of the topic..............................................................................................................4
LITERATURE REVIEW................................................................................................................5
The conceptual framework of capital structure in the context of organisational performance...5
The various determinants of capital structure in improving financial performance of small and
medium enterprise.......................................................................................................................7
REFERENCES..............................................................................................................................10
Books and journal.....................................................................................................................10

Introduction
Overview of the topic
Capital structure is the mixture of two vital elements that are equity and debt. It is used
by the company to raise fund for their overall operations and growth. Equity capital is raise
when the right of ownership share is granted to the person. This type of capital is also claims as
the future capital of the company. On the other side, Debt capital is defined as the capital which
is raise by issuing the bonds or loans (D’Amato, 2020). In a very short language, capital
structure is the combination of long term debts, short term debts and stock. Different industry
uses various types of capital structure as per their need and wants. Types of capital structure that
can be used by the organisation are Equity capital structure, Optimal capital structure, Financial
leverage structure, debt capital structure and many more. One of the important role of effective
capital structure is that it helps in managing the financial decision of the company. It also helps
in generating higher profit and financial performance can be improved (Hernández, Yañez-
Araque and Moreno-García, 2020). So it is very essential for the companies to keep the best
capital structure in order to balance their productivity and performance.
To carry out the investigation on the impact of capital structure on financial performance
the chosen sector is small and medium enterprise. A small enterprise is one where 10 to 50
employees are working and medium enterprise is one where 50- 250 employee works. For small
and medium enterprise having a effective capital structure is very important because it helps
them to allocate fund for their day to day operations (Eggers, 2020).
Research aim
To analysis the impact of Capital structure and its determinants on the financial performance of
the UK Small and medium enterprise
Research objectives
 To understand the conceptual framework of capital structure in the context of
organisational performance
 To analyse the various determinants of capital structure in improving financial
performance of small and medium enterprise

 To identify impact of Capital structure and its determinants on the financial performance
of the UK Small and medium enterprise
Research question
 What is the conceptual framework of capital structure in the context of organisational
performance?
 What are the various determinants of capital structure in improving financial performance
of small and medium enterprise?
 What is the impact of Capital structure and its determinants on the financial performance
of the UK Small and medium enterprise?
Significance of the topic
The present research study is related to give higher significance to small and medium
enterprise of UK. The topic is chosen so that they can know the importance of having effective
capital structure for the organisation (Dakua, 2019). Choosing the right type of capital structure
helps the SME's to increases the organisational profitability and productivity. Using the best
capital structure for the organisation assist the company in allocating and utilising the fund in
best manner. Apart from this the current investigation also provide in depth information
regarding the way the capital structure of the company can be used (Eller and et. al, 2020).

LITERATURE REVIEW
The conceptual framework of capital structure in the context of organisational performance
According to Lin, and et.al., (2018), the capital structure of the company is related to
company in providing an organised way to raise the capital is presented. It is defined as the
mixture of equity and debt which is utilised by the company. With the aim to make progress in
the finance field with the overall growth and operations (Ayaz, Zabri and Ahmad,2021). The
capital structure supports the company to improve the transnational efficiency of the company
and to elevate the level of flexibility in relation to raising funds. It can be seen that company
requires the financial capital in the way to operate the business. For most of the companies,
financial capital is raised up by making use and issuing the debt security or by selling common
stock. That is why the amount of debt and equity that marks up the capital structure of the
company has many risk. That is why the corporate management should use a prudent procedure
for creating and attaining the a target of the company. In the conceptual framework of capital
structure, the term debt involves the borrowed money which has been taken from the various
sources or lenders with the aim of paying them back as well as the interest amount. While the
equity is explained as the rights of the company without the requirement to pay back any further
investment. Therefore, the debt to equity ratio benefits in examining the risk of the borrowing
practices of the company. Also, the term capital is defined as the most significant and vital factor
for opening a business in well manner. There are two primary capital sources for an organisation
that is Debt and Equity (Chavali and et.al.,2019). With the aim of starting a business, the owner
invests their money or they make use of various sources, they take loans from the various ways
lender or other financial institution to pay them back with interest also. As it can be seen that
there are numerous types of sources with the help of organisation can raise their funds easily. For
example, preference shares, equity shares, long-term loans, retained earnings and many more. As
the funds plays a significant role to operate the activities of the business in an effective way. That
is why the term capital structure is considered essential for the company to regulate the complete
steadiness of the business in improved manner. Hence, the capital structure of an organisation is
divided in two categories such as the equity capital and debt capital. Whereas the equity capital
is defined as the money which is kept by the shareholders or owners of the company. Moreover,
there are two types of equity capital in capital structure such as the retained earnings and

contributed capital. The term retained earnings is described as the part of profit which has been
kept aside with the aim of helping the company in relation to strengthening their business.
As stated by Dinh (2020), the financial performance of the company is one of the main
issue in the company and the economy too. The companies try to make and bring the highest
financial performance in which various factors create major impact on the company’s
performance (Lin, and et.al.,2018). Such factors can be external or internal and they have a
relationship between the debt level of capital structure and the presentation of the businesses.
The capital structure provides a type of flexibility while raising funds because when the business
does not have the proper lenders then the future will be affected. Capital structure is the blend of
both vital elements such as the equity and debt. As it is utilised by the company in order to raise
fund for the complete actions and growth. Equity capital is required when the right of ownership
share is presented to the person. This type of capital also claims as the futuristic capital of the
company. Whereas the debt capital is explained as the capital which can be raised by issuing the
loans or bonds. It can also be said that capital structure is the blend of various sources such as
stock, long term debts and short term debts. Diverse industry makes use of various types of
capital structure as per their necessity and needs. There are various types of capital structure that
are used by the establishment such as Equity capital structure, Optimal capital structure,
Financial leverage structure and debt capital structure (Yazdanfar, Öhman and Homayoun,
2019). One of the significant part of effective capital structure is that it aids in dealing with the
financial decision of the company. Along with it, it also supports in making greater profit and
better financial position that is why it is important for the companies to hold the capital structure
in the best way in order to balance the performance and productivity. Both debt and equity have
their own benefits and weaknesses as the investors get the portion from the earnings. In which
the debt financing is also easier to transfer and hold managerially as compared to equity. When
any company want to start its business then they are to take care of the financial requirement in
relation to borrow money. Another issue while borrowing the money from bank is the time of
payment as it can impact the working of the monthly cash flow. Also, the banks loans require
long term commitment as compared to the shareholder investment. Investors are to be paid when
the business performs good while in case of bank the company is required to pay the interest and
the principal amount that too on time. It can also be seen that the company having bank loan
commitments on its balance sheet then it increases the debt-to-asset and debt-to-equity ratios. It

leads to make the company less attractive in front of the new creditors as well as potential
investors.
Figure 1:Capital Structure
The various determinants of capital structure in improving financial performance of small and
medium enterprise
According to the view of Vaidya (2022), optimum capital structure is described as the
ratio of debt and equity which is adopt by the company in order to maximise their wealth as well
as market value as well as minimise their cost of capital. It is mainly used for balancing the
worth and cost of a company. Capital structure described as sources of finance that are equity
and debt which are employed by the company in order to finance their operations. Debt refers to
as most cheaper form of financing than equity but it may inflict a financial risk. To get prevent
from this, companies optimise their capital structure by raising capital through equity for
alleviating the risk related to debt defaults. The capital structure of small and medium enterprise
are different from large companies because their resources, assets and production capacity are
smaller. These business are mostly owned by maximum 2-3 owners or single person where they
does not prefer to raise capital through equity as it divides the control of their business. The

owners of these businesses raise capital through equity that will affects their financial position.
There are many types of determinants of capital structure that helps small and medium enterprise
to improve their financial performance and help in making their business operation smoother and
effective. These determinants are described below:
Cost of Capital- Every single amount which is invested in a business is considered as
cost. It makes company able in order to return the finance that is provided by the suppliers. Cost
of equity is described the return which is offered to the equity holders and it is directly relative to
the degree of risk which is assumed by the company. On the other hand cost of debt is described
as interest which is paid in debts (Centobelli, Cerchione and Singh, 2019). The small and
medium enterprises are need to focus on raising their funds from those sources whose cost of
capital are low as it helps in improving their financial performance in better manner. The capital
structure of a company effectively return the cost of capital to it stakeholders than it can be
described as optimum capital structure.
Sales growth, profitability and stability- If an organisation earning good in the market,
has strong customer base as well as has constant demand of their product and service then its
goodwill ensures that the business run smooth manner. On the other side, if the company has low
growth and sales then it cause high risk as well as debt problems. Effective sales and
development of small and medium companies in order to deal with debt as well as repayments of
the interest. It is also important in order to determine the capital structure of a company.
Cash flow- For attaining optimum capital structure of the company, it is required to able
in order to generate cash flow for the company. Prediction about the future requirements and
shortages as well as conservation of the cash, help small and medium enterprises to create lower
preference or debt capital structure (Zhu, Zou and Zhang, 2019). This will also help them to
improve their financial performance and operate their business smoothly. It makes variability
and predictability of cash flow a very vital determinants of capital structure.
Company size- In early stage of small and medium enterprises raising the required
capital is one of the challenging task. On the other hand, a well established company can
effectively raise their capital through equity or debt. This shows that the size or stage of a
company creates significant impact on the capital structure. By dealing with these challenges, a
small or medium enterprise can effectively raise capital and improve their financial performance.
It is important for them to survive in the competitive market in longer term.

Risk- Every company struggles, assumes as well as anticipates with the risks while
operating and managing their business. When an organisation design an effective and optimum
capital structure then they easily deals with the two kinds of risk that are financial risk and
business risk. Business risks is directly relate with the changes of earnings, supply, income,
demand as well as revenue generations of the organisation (Demirel and Danisman, 2019). On
the other hand financial risk is relates with the market changes, entry of new competition or
substitute available in the market and these are not controlled by the company. So the small and
medium enterprises need to overcome all types of risk as it affects their overall capital structure.
It is important for making their financial performance good for operating their business in better
manner.
Inflation- Inflation is considered as one of the critical factor. When there is sudden rise
in goods and service of a company, then they suffers with the rise in electricity or power
consumption, equipment, raw material as well as machine cost. A little rise in the cost of these
expenses of the company can adversely affects the production level and the overall budget of the
companies. Because of this, small and medium enterprises faces many difficulties to deal with
these impacts and operate their business properly (Cantele and Zardini, 2018). This makes
important for an enterprise in order to design an optimum capital structure of the company to
deal with inflation issue in better manner. This will also helpful in making the financial
performance of small and medium enterprise good so, their business can operate smoothly.
Market Conditions- The market conditions are dynamic nature which creates difficulties
for the company to work in an active market by using their old and static measures along with
the business ways. Sometimes markets faces recession and sometime there is a massive boom in
the market. Small and medium enterprise faces many difficulties in order to deal with this
dynamic market condition that makes important to them to design optimum capital structure for
their company to operate their business in better manner (Exposito and Sanchis-Llopis, 2018). It
will also help in improving their financial performance.

REFERENCES
Books and journal
D’Amato, A., 2020. Capital structure, debt maturity, and financial crisis: empirical evidence
from SMEs. Small Business Economics. 55(4). pp.919-941.
Hernández, J.P.S.I., Yañez-Araque, B. and Moreno-García, J., 2020. Moderating effect of firm
size on the influence of corporate social responsibility in the economic performance of
micro-, small-and medium-sized enterprises. Technological Forecasting and Social
Change. 151. p.119774.
Eggers, F., 2020. Masters of disasters? Challenges and opportunities for SMEs in times of
crisis. Journal of business Research. 116. pp.199-208.
Dakua, S., 2019. Effect of determinants on financial leverage in Indian steel industry: A study on
capital structure. International Journal of Finance & Economics. 24(1). pp.427-436.
Eller, R., and et. al, 2020. Antecedents, consequences, and challenges of small and medium-
sized enterprise digitalization. Journal of Business Research. 112. pp.119-127.
Ayaz, M., Zabri, S.M. and Ahmad, K., 2021. An empirical investigation on the impact of capital
structure on firm performance: evidence from Malaysia. Managerial Finance.
Chavali, K. and Rosario, S., 2018. Relationship between capital structure and profitability: A
study of Non Banking Finance Companies in India. Academy of Accounting and
Financial Studies Journal, 22(1), pp.1-8.
Jarallah, S., Saleh, A.S. and Salim, R., 2019. Examining pecking order versus trade‐off theories
of capital structure: N ew evidence from J apanese firms. International Journal of
Finance & Economics, 24(1), pp.204-211.
Lin, T.L., Liu, H.Y., Huang, C.J. and Chen, Y.C., 2018. Ownership structure, board gender
diversity and charitable donation. Corporate Governance: The international journal of
business in society.
Yazdanfar, D., Öhman, P. and Homayoun, S., 2019. Financial crisis and SME capital structure:
Swedish empirical evidence. Journal of economic studies, 46(4), pp.925-941.
Centobelli, P., Cerchione, R. and Singh, R., 2019. The impact of leanness and innovativeness on
environmental and financial performance: Insights from Indian SMEs. International
Journal of Production Economics, 212, pp.111-124.
Zhu, Q., Zou, F. and Zhang, P., 2019. The role of innovation for performance improvement
through corporate social responsibility practices among small and medium‐sized
suppliers in C hina. Corporate Social Responsibility and Environmental
Management, 26(2), pp.341-350.
Demirel, P. and Danisman, G.O., 2019. Eco‐innovation and firm growth in the circular economy:
Evidence from European small‐and medium‐sized enterprises. Business Strategy and the
Environment, 28(8), pp.1608-1618.
Cantele, S. and Zardini, A., 2018. Is sustainability a competitive advantage for small businesses?
An empirical analysis of possible mediators in the sustainability–financial performance
relationship. Journal of cleaner production, 182, pp.166-176.
Exposito, A. and Sanchis-Llopis, J.A., 2018. Innovation and business performance for Spanish
SMEs: New evidence from a multi-dimensional approach. International Small Business
Journal, 36(8), pp.911-931.

Online:
Vaidya, D., 2022 [Online]. Available through: <https://www.wallstreetmojo.com/optimum-
capital-structure/>