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What is a Capital Structure?
What’s important to know about it?
In this article, I will break down the meaning of Capital Structure so you know all there is to know about it!
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What Is Capital Structure
In corporate finance, capital structure refers to the combination of debt and equity used by a company to raise capital to finance its operations.
In other words, a company’s capital structure is composed of equity capital and debt providing the company the liquidity and financing it needs to fund its operations and growth.
For example, a company that has issued common shares and bonds will have both equity and debt in its capital structure.
Equity capital can include things like common shares, preferred shares, Class A shares, or any other type of equity securities.
Debt capital can include things like loans, bonds, debentures, or other types of debt financing.
When a company raises capital through equity capital, it is giving the investor certain ownership rights in the company.
On the other hand, a company that raises capital through debt financing will borrow money and will be required to reimburse the principal along with interest over a period of time.
Keep reading as I will further break down the meaning of capital structure and tell you how it works.
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Why Capital Structure Is Important
Understanding a company’s capital structure is important to be able to see how it is financed and how much risk investors and creditors will be exposed to.
In general, companies can raise capital in two ways: equity capital and debt capital.
Raising capital through equity means that the company sells ownership rights to investors in exchange for the capital.
Investors will then have a claim to the future cash flow and profits of the company.
Another way to raise capital is by issuing debt and borrowing money.
When a company borrows too much money, investors will consider the company to expose them to greater risk as the company will need to generate sufficient cash flow to pay for its debt obligations on time.
A company that is too heavily financed through debt will be more exposed to liquidity risk and end up in financial trouble.
Investors look at a company’s debt-to-equity ratio to see how the company is using debt and equity to finance its operations.
Every company should find the right balance between debt and equity financing to ensure that it optimizes its capital structure.
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Factors Affecting Capital Structure
There are different factors that may affect a company’s capital structure.
One factor is the company’s life cycle.
In essence, companies are organizations that evolve over time where in the beginning they need a lot more capital to finance their operations.
Over time, as the company’s business matures, it will no longer need to raise as much capital and can rely on its own sources of capital.
The cost of capital can also be an important consideration for company management.
Every company’s objective should be to reduce its cost of capital to maximize shareholder value.
Depending on the market conditions, in some cases, companies should rely on equity capital and at other times raise capital through debt.
A company may also see changes in its capital structure depending on how the business is going.
If a company is faced with declining sales or rapid growth, it may need to quickly react to obtain the capital it needs to be able to continue operations without interruption.
This can result in changes in the company’s capital structure.
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Pros And Cons of Debt And Equity
Both debt and equity are different ways a company can get the financing it needs to operate its business.
However, debt and equity each offer some benefits and have drawbacks.
Here are the most notable pros and cons of using debt and equity.
The main advantages of debt capital are:
- There are many lenders in the market
- Companies can generally borrow money quite rapidly
- Debt capital is cheaper than equity capital
- Investors require a lower rate of return than equity
The main disadvantages of debt capital are:
- The company is legally obligated to make interest payments
- The company must make payments at predetermined dates
- The lender has a claim on the company’s assets in case of nonpayment
- In many cases, lenders require companies to respect certain financial covenants
- Lenders may impose various restrictions on the company
The main advantages of equity capital are:
- The company does not have interest payments
- The company does not have to reimburse the investment
- The company does not have an obligation to pay dividends
- Investors can acquire control of the company
- Investors can cast their vote on important decisions
- Equity capital provides higher operational flexibility
The main disadvantages of equity capital are:
- Investors expect a higher rate of return than debt capital
- The company must give up ownership rights
- Investors can eventually take control of the company
- Investors have a claim on the assets of the company in the event of liquidation
- Equity capital is typically more expensive than debt capital
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Capital Structure FAQ
What is the optimal capital structure for a company?
A company’s capital structure is determined by the ratio of debt and equity it uses to fund its operations.
In general, investors and analysts consider that a company’s optimal capital structure is the one that provides the lowest weighted average cost of capital for the company.
How does capital structure change by industry?
Companies operating in different industries can have very different capital structures.
For example, a mining company may not be able to use debt capital as much as other companies as it may not have consistent cash flows to be able to pay its debt obligations on time.
On the other hand, companies that are able to consistently generate a high amount of cash, such as banks and insurance companies, can raise more capital through debt as they know they will have the cash flow to pay for their debt obligations.
Can the company change its capital structure?
Yes, a company can change its capital structure by using different recapitalization methods.
The most common recapitalization methods used by companies are to issue debt to repurchase equity, issue debt and pay dividends, or issue equity to repay debt.
This way, a company can change the proportion of debt to equity it uses to fund its business.
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So there you have it folks!
What does capital structure mean?
In a nutshell, capital structure refers to the specific combination of debt and equity used by a company to fund its business operations.
Equity capital will typically be a more expensive type of financing but offers greater financial flexibility to companies.
Debt financing is usually a cheaper type of financing but will require the company to make specific payments over a period of time to pay off the amount borrowed.
Capital structure includes shareholders’ equity, debt, and preferred stocks appearing on a company’s balance sheet.
In general, debt capital is a cheaper source of capital but imposes a greater financial burden on the company than equity capital.
Companies should find the right debt to equity ratio to ensure they are funding their business operations with an optimal mix of debt to equity.
Now that you know what capital structure means and how it works, good luck with your research!
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