Capital structure describes a firm's finances in terms of the balance between its debt and equity. A business's management team and other stakeholders will consider the proper mix of debt and equity for their ideal capital structure.
Learn more about this way of assessing a business's finances, and some of the factors that business leaders consider as they construct their capital structure.
What Is Capital Structure?
"Capital," in the business world, is simply money. Therefore, capital structure is the way that a business finances its operations—the money used to buy inventory, pay rent, and other things that keep the business's doors open.
Specifically, capital structure details a business's composition of debt and equity, including long-term debt, specific short-term liabilities (like banknotes), common equity, and preferred equity. This mix of debts and equities make up the finances used for a business's operations and growth. For example, the capital structure of a company might be 40% long-term debt (bonds), 10% preferred stock, and 50% common stock.
How Does Capital Structure Work?
Business leaders need to independently come up with a capital structure that works best for their operation. Should more debt financing be used to protect ownership and earn a higher return? Should more equity financing be used to avoid the risk of excessive debt and bankruptcy? These choices have to be made on a case-by-case basis, at both small businesses and large corporations.
Any type of debt or equity is accounted for the capital structure. For instance, debt includes traditional business loans, but it also includes any supplier credit the business receives.
Both debt and equity come with costs, and these are known as the cost of capital. A simple cost of capital is the interest rate paid on a loan, but all forms of financing have their cost. Equity financing comes at the cost of some ownership stake in the business.
It's common to assess a company's capital structures using ratios like the debt-to-equity ratio. This allows analysts to quickly gauge how much of the company's capital structure is made up of debt and how much is equity financing.
The different kinds of costs of capital make it important for businesses to balance their capital structure. The capital with the lowest costs should, ideally, make up the largest proportion of a business's capital structure.
In practice, the costs of capital have to be balanced with a capital structure that fits the business model. For instance, a cyclical business may not be able to afford to take on much debt, even if the interest rates pose a lower cost of capital than alternatives like equity financing. If it can't afford to make the loan payments during the slow periods of its business cycle, the business must instead build a capital structure with other types of financing.
During a business's lifespan, it may choose to alter its capital structure. This is known as recapitalizing. Just as forming an initial capital structure is an individual process, the process of recapitalizing can take many different forms.
A business can recapitalize by essentially exchanging debt for equity. It can acquire more debt—either by issuing corporate bonds or by taking on a business loan—and then use that leverage to purchase back some of its equity in the form of a share buyback.
Conversely, if a business feels like its debt is getting out of hand, it might issue new stock. The new stock issue will bring in cash in exchange for equity, and that cash can be used to pay off a loan or otherwise reduce the business's debt.
- Capital structure refers to the way that a business is financed—the mix of debt and equity that allows a business to keep the doors open and the shelves stocked.
- A company's ideal capital structure will depend on its specific situation, including factors like the cost of capital, the business cycle, and any existing debt or equity.
- When a company exchanges one type of financing for another—such as taking on debt to buy back stock shares—that is known as recapitalization.