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Cap Structure

The document discusses capital structure, which refers to the combination of debt and equity that a company uses to finance its overall operations. It explains that debt consists of borrowed money that must be paid back, while equity involves ownership in the company without repayment. The key ratio for analyzing a company's capital structure is its debt-to-equity ratio, which provides insight into how risky its borrowing practices are. The document also outlines different types of debt and equity that make up a company's capital structure and how adjusting the proportions can impact its risk level and growth potential.

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141 views

Cap Structure

The document discusses capital structure, which refers to the combination of debt and equity that a company uses to finance its overall operations. It explains that debt consists of borrowed money that must be paid back, while equity involves ownership in the company without repayment. The key ratio for analyzing a company's capital structure is its debt-to-equity ratio, which provides insight into how risky its borrowing practices are. The document also outlines different types of debt and equity that make up a company's capital structure and how adjusting the proportions can impact its risk level and growth potential.

Uploaded by

Invisible Cion
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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CORPORATE FINANCE & ACCOUNTING CORPORATE FINANCE

Capital Structure

By ALICIA TUOVILA

Reviewed By AMY DRURY

Updated Jul 14, 2020

What Is Capital Structure?

The capital structure is the particular combination of debt and equity used by a company to finance its
overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come
in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered
to be 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.

Capital Structure

Understanding Capital Structure

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance
sheet, are purchased with this debt and 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 proportion of short-term
debt versus long-term debt is considered when analyzing its capital structure.

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. Usually, 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 be the primary source of the firm’s growth.

Debt is one of the two main 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 may be
tax deductible. Debt also 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 in 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 in the case of declining earnings. On the other hand, equity
represents a claim by the owner on the future earnings of the company.

Measures of Capital Structure

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. That said, a high leverage ratio
and an aggressive capital structure can also 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, also referred to as the
optimal capital structure, to finance operations.

Analysts use the debt-to-equity (D/E) ratio to compare capital structure. It is calculated by dividing total
liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their
corporate strategies. At times, however, companies may rely too heavily on external funding, and debt
in particular. Investors can monitor a firm’s capital structure by tracking the D/E ratio and comparing it
against the company’s industry peers.

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Related Terms
This Gearing Doesn’t Mean Faster or Slower

Gearing refers to the ratio of a company’s debt relative to its equity; if it’s high, then a firm may be
considered as highly geared (or leveraged). More

Debt-To-Equity Ratio – D/E

The debt-to-equity (D/E) ratio indicates how much debt a company is using to finance its assets relative
to the value of shareholders’ equity. More

Leverage Ratio

A leverage ratio is any one of several financial measurements that look at how much capital comes in
the form of debt, or that assesses the ability of a company to meet financial obligations. More

Understanding the Sustainable Growth Rate (SGR)

The sustainable growth rate (SGR) is the maximum rate of growth that a company can sustain without
raising additional equity or taking on new debt. More

Deleveraging: What It Means, and How It Works

Deleveraging is when a company or in`dividual attempts to decrease its total financial leverage. More

Long-Term Debt to Capitalization Ratio

The long-term debt to capitalization ratio, calculated by dividing long-term debt by available capital,
shows the financial leverage of a firm. More

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