What Does Capital Structure Mean?
Capital structure refers to a company’s collective outstanding debt and equity. It allows a firm to understand what kind of funding the company uses to finance its overall activities and growth. In other words, it shows the proportions of senior debt, subordinated debt and equity (common or preferred) in the funding. Retained earnings are also listed on the equity side of the balance sheet when computing capital structure, while short-term debt is added to the company’s other debts. The purpose of capital structure is to provide an overview of the level of the company’s risk. As a rule of thumb, the higher the proportion of debt financing a company has, the higher its exposure to risk will be. In most cases, a company that is financed primarily by debt will have a more aggressive capital structure, which means that investors who invest in the company are taking a greater risk. But it should be noted that this risk could well be the company’s primary source of growth.
Debt is made up of all of the money that came from a third-party lender that must be repaid. Equity represents an ownership stake in a company that does not need to be repaid in any sense. Both types of financing are used to purchase assets for the company. Debt can be more appealing because it allows the founder(s) of the company to retain their share of ownership.
There can also be tax advantages, as the interest that is charged on the debts of a business is usually tax-deductible as a legitimate business expense. And it is easy to obtain debt financing when interest rates are low and credit is plentiful.
Equity is more expensive and also dilutes the ownership of the company, but it also doesn’t cost anything. This can be beneficial if earnings start to decline.
Capital structure is commonly known as the debt-to-equity ratio.
Divestopedia Explains Capital Structure
A company’s capital structure points out how its assets are financed. When a company finances its operations by opening up or increasing capital to an investor (preferred shares, common shares, or retained earnings), it avoids debt risk, thus reducing the potential that it will go bankrupt. But all owners of the company will have a proportional share of claim on the company’s earnings from that point on. Moreover, the owner may choose debt funding and maintain control over the company, increasing returns on the operations.
As mentioned previously, companies that use debt as their primary source of financing are said to be highly leveraged and will carry a more aggressive capital structure. Companies that are financed primarily through the distribution of equity have more conservative capital structures. However, highly-leveraged companies also offer the possibility of higher returns, while those with low leverage will generally grow at a slower pace over time.
Debt can take the form of a corporate bond issue, a long-term loan, or short-term debt. The latter directly impacts the working capital. Having said that, a company that is 70% debt-financed and 30% equity-financed has a debt-to-equity ratio of 70%; this is the leverage. It is very important for a company to manage its debt and equity financing because a favorable ratio will be attractive to potential investors in the business. The debt-to-equity ratio is computed by dividing the total amount of debt that a company carries by the total amount of equity in the company.
Shrewd companies will often try to achieve an optimal capital structure that maximizes the company’s market value while keeping the cost of capital to a minimum. Debt financing is usually cheaper than equity because of the tax deductions it affords. But companies that become too highly leveraged can lose their attractiveness to all but the most aggressive investors.