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 in the form of bond issues or loans, while equity can be from common stock, preferred stock, or retained earnings. Short-term debt is also part of the capital structure.
Key Takeaways
- Capital structure is how a company funds its overall operations and growth.
- Debt consists of borrowed money that is due back to the lender, commonly with interest expense.
- Equity consists of ownership rights in the company, without the need to pay back any investment.
- The debt-to-equity (D/E) ratio is useful in determining the riskiness of a company’s borrowing practices.
Dynamics of Debt and Equity
Both debt and equity can be found on the balance sheet. Company assets, also 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. The proportion of short-term debt versus long-term debt is considered when analyzing its capital setup.
When analysts refer to capital structure, they are most likely referring to a firm’s debt-to-equity (D/E) ratio, which provides insight 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 greater risk to investors. This risk, however, may sometimes be the primary source of the firm’s growth.
Debt is advantageous for companies because of tax benefits; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company to retain ownership compared to equity. In times of low-interest rates, debt is abundant and easy to access.
Equity allows outside investors to take partial ownership of the company. Although more expensive than debt, especially when interest rates are low, equity does not require repayment. This is beneficial to the company in case of declining earnings. However, equity represents a claim by the owner on future earnings.
Optimal Capital Structure
Companies that use more debt than equity to finance their assets 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. However, an aggressive capital structure can lead to higher growth rates, whereas a conservative one can lead to lower growth rates.
Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies effectively incorporate both debt and equity into their corporate strategies. However, companies may sometimes rely too heavily on external funding, particularly debt. Investors can monitor a firm’s capital structure by tracking the D/E ratio and comparing it to industry peers.
Company management aims to find the ideal mix of debt and equity, also referred to as the optimal capital structure, to finance operations efficiently.
Why Do Different Companies Have Different Capital Structures?
Firms in different industries utilize varying capital structures suited to their business types. Capital-intensive industries like auto manufacturing may use more debt, while labor-intensive or service-oriented firms like software companies may prioritize equity.
How Do Managers Decide on Capital Structure?
With access to capital, companies aim to minimize their cost of capital. This can be achieved using a weighted average cost of capital (WACC) calculation. Managers or analysts multiply the cost of each capital component by its proportional weight to calculate WACC.
How Do Analysts and Investors Use Capital Structure?
A company with too much debt can be viewed as a credit risk, whereas too much equity may indicate underutilized growth opportunities or high capital costs. There is no universal ratio of debt to equity for an optimal capital structure. It varies depending on the industry, the company’s development stage, and external factors like interest rates and regulatory environment.
What Measures Do Analysts and Investors Use to Evaluate Capital Structure?
Besides WACC, several metrics are used to estimate the suitability of a company’s capital structure. Leverage ratios, including the debt-to-equity (D/E) ratio or debt ratio, are commonly utilized.
The Bottom Line
Capital structure is the specific mix of debt and equity that a company uses to finance its operations and growth. Debt involves borrowed money that must be repaid, often with interest, while equity represents ownership stakes in the company. The D/E ratio is a frequently used measure of a company’s capital structure, providing insight into its risk level. Companies with a high proportion of debt in their capital structure may pose higher risks for investors but have potential for greater growth.
Related Terms: leverage ratio, cost of capital, balance sheet, interest expense.
