Capital Structure

What Is Capital Structure?

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes as bond issues or loans, while equity might come as common stock, preferred stock, or retained earnings. Short-term debt is likewise considered to be part of the capital structure.

Understanding Capital Structure

Both debt and equity can be found on the balance sheet. Company assets, additionally listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's extent of short-term debt versus long-term debt is considered when breaking down its capital structure.

When analysts refer to capital structure, they are probably referring to a company's debt-to-equity (D/E) ratio, which provides understanding into how risky a company's borrowing practices are. Typically, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses a greater risk to investors. This risk, however, might be the primary source of the company's growth.

Debt is one of the two fundamental ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds might be tax-deductible. Debt likewise allows a company or business to retain ownership, unlike equity. Additionally, in times of low-interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company on account of declining earnings. Then again, equity represents a claim by the owner on the future earnings of the company.

Special Considerations

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. All things considered, a high leverage ratio and an aggressive capital structure can likewise lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

It is the goal of company management to find the ideal mix of debt and equity, additionally referred to as the optimal capital structure, to finance operations.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Wise companies have learned to incorporate both debt and equity into their corporate strategies. Now and again, however, companies might rely too heavily on external funding and debt in particular. Investors can monitor an association's capital structure by tracking the D/E ratio and looking at it against the company's industry peers.

Highlights

• Debt comprises of borrowed money that is due back to the lender, commonly with interest expense.
• Equity comprises of ownership rights in the company, without the need to pay back any investment.
• Capital structure is the manner by which a company funds its overall operations and growth.
• The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company's borrowing practices.

FAQ

How Do Analysts and Investors Use Capital Structure?

A company with too much debt should be visible as a credit risk. Too much equity, however, could mean the company is underutilizing its growth opportunities or paying too much for its cost of capital (as equity tends to be more costly than debt). Unfortunately, there is no magic ratio of debt to equity to use as guidance to achieve real-world optimal capital structure. What defines a healthy blend of debt and equity varies depending on the industry the company operates in, its stage of development, and can shift over time due to external changes in interest rates and regulatory environment.

For what reason Do Different Companies Have Different Capital Structure?

Firms in different industries will use capital structures better suited to their type of business. Capital-intensive industries like auto manufacturing might utilize more debt, while work intensive or service-oriented firms like software companies might prioritize equity.

What Measures Do Analysts and Investors Use to Evaluate Capital Structure?

In addition to the weighted average cost of capital (WACC), several metrics can be used to estimate the suitability of a company's capital structure. Leverage ratios are one group of metrics that are used, like the debt-to-equity (D/E) ratio or debt ratio.

How Do Managers Decide on Capital Structure?

Expecting that a company approaches capital (e.g. investors and lenders), they will need to minimize their cost of capital. This should be possible utilizing a weighted average cost of capital (WACC) calculation. To calculate WACC the manager or analyst will increase the cost of each capital component by its proportional weight.