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Oct.2004 Volume 3, No.10 (Serial No.16) China-USA Business Review, ISSN 1537-1514 USA-China Business Review(Journal),Inc.,USA How to Determine the Financial Structure of an Enterprise Ziliang Zhong* Abstract: The financial structure is the proportion of every part of the capital in an enterprise. Whether the financial structure is scientific or not has an important impact on the risk degree, development prospect and profit-making ability of the enterprise. In this thesis, the author will discuss how to determine the financial structure of an enterprise scientifically. Key words: financial structure capital financial leverage 1. The Theory Base of Determining the Financial Structure The financial structure should be determined under the guidance of scientific theories. Among so many economic theories that have something to do with the financial structure, the most important two are harmonious theory and human capital theory. 1.1 Harmonious Theory It was set up by Jensen, Meckling, Warner and Myers in 1976 and 1977 on the basis of MM theory. According to this theory, it is usual for an enterprise to fall into financial crisis and even go bankrupt because of heavily debt. In case the financial crisis comes, whether going bankrupt or not, the enterprise will certainly suffer too much loss. Therefore, when determining the financial structure, the enterprise should weigh between the low cost, preferential tax brought up by borrowing and the losses brought up by financial crisis carefully. It is worthwhile to borrow only when the former is bigger than the latter. 1.2 Human Capital Theory Human capital is the capital invested for human resources. Human capital theory is a theory about human capital’s increase and decrease as well as the effect on the production and operation activities of an enterprise. Its representatives are Schultz, Mincer and Becker. In new economy, human resources play a more and more important role in the production and operation activities of an enterprise, and the human resources investments of an enterprise are continuously increased. Therefore, to capitalize the human resources investment, strengthen the development and utilization of human resources is the time’s demand, and also accords with the human capital theory. 2. Forecasting the Capital Demand One important prerequisite of determining financial structure is to know how many funds are required for the production and operation activities of an enterprise. So we should forecast the fund demand for each accounting period of the enterprise. 2.1 Forecasting the Short-term Fund Demand The short-term fund demand is the fund required for daily operation activities. Because the insufficiency of * Ziliang Zhong, Ph.D. candidate of Management School, Xi’an Jiaotong University, Xi’an, Shaanxi, China, Postcode: 710049; 59 How to Determine the Financial Structure of an Enterprise short-term fund usually shows the enterprise could not repay the maturity debts, and the enterprise mainly repays them in currency, the forecast of short-term fund demand mainly forecast to the cash demand. The forecast methods of cash demand include cash flow analysis, net income adjustment and balance sheet estimation, etc. But the most common method is the cash flow analysis. 2.2 Forecasting the Long-term Fund Demand The long-term fund demand is the fund quantity required for the long-term investments, such as fixed output investment, immaterial assets investment and human resources investment, etc. The forecast method is usually to collect all the related information about expenditures that may happen for the long-term investment. 3. Reducing the Capital Cost There are many channels for an enterprise to raise fund. Each channel will certainly need to pay some cost, including the fund raising cost and fund tie-up cost, which is called the capital cost. For different channel, the raising difficulty and capital cost is different, so the enterprise should weigh all the costs of different capital sources carefully, strive for the best capital constitute, so as to minimize the total capital cost. The formulas of capital cost are as follows: (1) Liabilities cost rate＝interest rate (1-income tax rate) / (1-cost rate of fund raising) (2) Preferred stock cost rate＝dividend per share/issue price (1-inssue cost rate) (3) Common stock cost rate＝dividend per share/issue price per share (1-inssue cost rate) + dividend growth rate (4) Human stock cost rate＝dividend per share/authorized value per share (1-recruiting cost rate) + dividend growth rate (5) Comprehensive cost rate＝∑capital cost rate of each kind of capital*the proportion of this kind of capital in the total capital 4. Determining the Financial Structure Scientifically 4.1 Making Rational Use of Financial Leverage The financial leverage is a means to adjust gains on owners’ capital with borrowing. As we known, the cost of capital that owners input is variable and repaid after income tax; but the liability cost is regular and repaid before income tax. No matter how much the profit before interest and income tax will be, should the liability cost be deducted first, the remaining sum belongs to owners. Therefore, the financial leverage has an important effect on gains of owners’ capital. Sometimes it brings up additional income for owners, which is called the financial leverage gains; sometimes it brings up additional loss for owners, which is called the financial leverage risk. It is thus clear that the financial leverage is a double edge sword. The enterprise should be careful to use it. Usually, E-mail: email@example.com 60 How to Determine the Financial Structure of an Enterprise the ratio of liabilities to owners’ equity should be kept 1:1 or so. 4.2 Determining the Ratio of Short-term Liabilities to Long-term Liabilities This ratio reflects the different degree of the enterprise relies on short-term liabilities and long-term liabilities. The higher the ratio is, the more the degree of relying on short-term liability is, and vice versa. If the risk of repaying liability is not high, the higher ratio of short-term liabilities to long-term liabilities may bring up more financial leverage gains for owners. But when determining the ratio, the assets structure of the enterprise should be also thought over. Generally, the long-term liabilities should be used to sustain long-term assets and stability short-term assets; the short-term liabilities should be used to sustain floating short-term assets. Usually, the ratio should be kept 1: 2 or so. 4.3 Determining the Ratio of Preferred Stock to Common Stock The preferred stock is a measure of fund raising between common stock and bond. Its cost is lower and its risk is higher than common stock’s. During the founding stage, generally, because the operation prospect is unclear, the enterprise may issue more preferred stocks than common stocks. However, during the growth stage, the enterprise has a stronger competitive power and should issue more common stocks than preferred stocks. 4.4 Determining the Human Resources Share The human resources investments are those that laborers input on themselves and belong to laborers themselves and should be confirmed as laborers’ equity. So the enterprise should appraise the human resources values and grant appropriate shares to laborers according to the appraise result. The ratio of human resources shares to total shares of an enterprise may be determined according to the content of science and technology of the enterprise. For the hi-tech enterprise, it should be higher; for the common enterprise, it should be lower. References: 1. Yada Yang. Capital Structure Optimization & Capital Operation, Dalian: Northeast Finance & Economics University Publishing House, 2001 2. Ziliang Zhong. A New Concept of Equity Accounting, Finance & Economics Research, 2003(3): 78-83 3. Jacob Mincer. Studies in Human Capital, London: Edward Elgar Publishing House Limited, 1993 4. Bin Wang. Review on Stock Structure, Beijing: Chinese Finance & Economics Publishing House, 2001 5. Deren Xie. Research on the Accounting Confirmation of Managers’ Stock Option, Accounting Research, 2002(9): 25-30 (Edited by Xueping Ye, Zhenfeng Zhang and Royaig) 61
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