What is the capital structure?
A capital structure is a particular combination of debt and capital that a company uses to finance its overall business and growth. Equity arises from the shares owned by the company and claims future cash flows and profits. Liabilities are offered in the form of bonds or loans, while equity may be offered in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered part of the capital structure.
- The capital structure is a way for a company to fund its overall business and growth.
- Debt consists of borrowings that are repaid to the lender and is usually accompanied by interest expense.
- Equity is made up of company ownership and does not require you to repay your investment.
- Debt equity (D / E) ratios help determine the risk of a company’s borrowing practices.
Understand the capital structure
Both liabilities and equity are listed on the balance sheet. The company’s assets, which are also listed on the balance sheet, are purchased with this liability and capital. The capital structure can be a mixture of long-term debt, short-term debt, common stock, and preferred stock of the company. When analyzing the capital structure, the ratio of short-term debt to long-term debt of a company is taken into consideration.
When analysts refer to capital structure, they are likely to refer to a company’s debt-capital (D / E) ratio, which provides insight into how risky a company’s borrowing practices are. increase. Companies that raise large amounts of money usually have a more aggressive capital structure, which poses greater risk to investors. However, this risk can be a major source of corporate growth.
Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of their tax benefits. Interest payments made as a result of borrowing funds may be tax deductible. Debt, unlike stock, also allows a company or company to retain ownership. Moreover, in an era of low interest rates, debt is plentiful and accessible.
Equity allows external investors to take partial ownership of the company. Stocks are more expensive than debt, especially when interest rates are low. However, unlike debt, you do not have to repay your capital. This is a benefit for the company in the event of reduced revenue. Equity, on the other hand, represents the owner’s claim for the company’s future revenue.
Measurement of capital structure
Companies that use more debt than equity to finance their assets and operating activities have a high leverage ratio and a positive capital structure. Companies that pay for assets that have more capital than liabilities have a lower leverage ratio and a more conservative capital structure. That said, high leverage ratios and aggressive capital structures can also lead to higher growth rates, while conservative capital structures can lead to lower growth rates.
Management’s goal is to find the ideal combination of debt and capital, also known as the optimal capital structure, to finance a business.
Analysts use debt equity (D / E) ratios to compare capital structures. It is calculated by dividing total liabilities by total capital. Familiar companies have learned to incorporate both debt and capital into their corporate strategy. However, companies may be overly dependent on external funds, especially debt. Investors can monitor a company’s capital structure by tracking the D / E ratio and comparing it to its peers.
Why do different companies have different capital structures?
The capital structure is the ratio of equity to debt finance that a company uses to run and grow its business. Administrators need to weigh the costs and benefits of raising each type of capital against the ability to raise one or the other. Equity capital involves diluting some of the company’s ownership and voting rights, but it reduces the obligations to investors for repayment. Debt tends to be cheaper in capital (and has tax benefits), but it carries significant liability for interest and principle repayment. This can lead to defaults or bankruptcy if not done. Companies in different industries use a capital structure that is more suited to their type of business. Capital-intensive industries such as automakers may utilize more debt, while labor-intensive or service-oriented companies such as software companies may prioritize fairness.
How does the manager determine the capital structure?
Assuming a company has access to capital (such as investors and creditors), you will want to minimize the cost of capital. This can be done using the Weighted Average Cost of Capital Cost (WACC) calculation. To calculate WACC, the manager or analyst multiplies the cost of each capital component by its proportional weight. Companies need to weigh the absolute cost of capital against the risk of default. As a result, the optimal capital structure includes both debt and capital.
How do analysts and investors use the capital structure?
According to economists Franco Modigliani and Merton Miller, in an efficient market, corporate value is completely unaffected by the capital structure in the absence of taxes, bankruptcy costs, agency costs and information asymmetry. However, if a company has too much debt, investors often consider it a credit risk. They may think that there is too much equity and the company is diluting ownership too much. Unfortunately, there is no magical debt-to-capital ratio to use as guidance for achieving optimal real-world capital structures. What defines a healthy blend of debt and capital depends on the industry, business unit, and stage of development of the company involved, and can change over time due to changes in interest rates and external changes in the regulatory environment. However, it makes sense that the optimal balance generally needs to reflect lower levels of debt and higher levels of equity, as investors are better off investing in companies with strong balance sheets.
What indicators do analysts and investors use to assess their capital structure?
In addition to WACC, there are several metrics that can be used to estimate the goodness of a company’s capital structure. Leverage ratio is a group of metrics used to place debt in relation to equity. Debt equity (D / E) ratios are one common example, along with the degree of financial leverage (DoL).