An Introduction to Capital Structure

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A company's capital structure refers to the type of money that funds the business and the source of those funds. Capital structure can have an impact on the return a company earns for its shareholders. It can also determine if a firm survives a recession or depression.

Learn more about the basics of capital structure.

Key Takeaways

  • Capital structure refers to the relationship between debt and equity—the two main forms of capital in a business.
  • It is typically measured in terms of the debt-to-equity ratio. A ratio greater than 1.0 means the company is financed more by debt than equity.
  • Knowing the relationship between these two concepts helps investors assess the risk level of a business.
  • Healthy businesses know how to leverage debt within their business model.

Capital Structure—What It Is and Why It Matters

The term "capital structure" refers to the percentage of capital (money) at work in a business by type. Broadly speaking, it comes in two forms: equity capital and debt capital.

Each type of capital has its pros and cons. A balance is needed to sustain business growth. A large part of wise corporate stewardship and management is trying to create a capital structure that offers the ideal balance of risk and reward for shareholders.

Capital structure is important for Fortune 500 companies. It's also key for small-business owners trying to figure out how much of their startup money should come from a bank loan. Too much debt can put the business in danger.

Investors, shareholders, and analysts often look at a business's debt-to-equity ratio to assess if the business is a sound investment. If this ratio is higher than 1.0, the company is financed by more debt than equity.

Another part of capital structure is working capital, which is the cash a company has on hand. Working capital is the difference between a business's assets and liabilities.

A business with more debt than equity has more liabilities than assets. It is often seen as more risky to invest in. This can vary by industry.

Equity Capital 

Many owners fund new businesses with their money. That can be savings. Sometimes it comes from family members. A retirement plan may be tapped. One common source of funding for growing companies is equity.

Equity capital refers to money put up by the shareholders, who are then owners. This form of capital comes in two types.

Contributed Capital

This is money invested in the business in exchange for shares of stock or ownership. Contributed capital can come from shareholders. It may also come from angel investors and venture capitalists (VCs).

Capital from angels and VCs is more rare and harder to access, Angels finance less than 3% of new businesses. VCs fund fewer than 1%. These types of funding force owners to give up a degree of control over their business in return.

Retained Earnings

This form of capital is profits from past years kept by the company and used to strengthen the balance sheet. It can also fund growth, acquisitions, or expansion

Equity capital can be the most expensive form of capital a company can use. That's because its "cost" is the return that the firm must earn to attract investment.

An unproven startup, for instance, may need a higher return on equity to convince investors to purchase the stock. By contrast, it's easier for a well-known company such as Procter & Gamble to attract investors. P&G sells household brands that cover a wide range, from toothpaste and shampoo to laundry detergent and beauty products.

Debt Capital

The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The cost depends on the health of the company's balance sheet. A firm that is AAA rated can borrow at very low rates. Meanwhile, a risky company with tons of debt may have to pay 15% or more in exchange for debt capital.

There are different varieties of debt capital.

Loans or Credit Cards

Many businesses start with loans from family or put expenses on a credit card. Many also apply for loans from banks or the Small Business Administration (SBA). Small banks can be good sources of funding for new businesses.

When applying for a loan from a bank or the SBA, you will need to show a business plan. Lenders also want to see projected financials for at least five years, and an expense sheet.

Long-Term Bonds

This is generally considered the safest type of debt. That's because the company has years, even decades, to come up with the principal. In the meantime, it pays only interest.

Short-Term Commercial Paper

Used by giants such as Walmart and General Electric, this amounts to billions of dollars in 24-hour loans from the capital markets. It can help businesses meet day-to-day working capital requirements such as payroll and utility bills.

Vendor Financing

In this instance, a company can sell goods before it has to pay the bill to the vendor. That can increase the return on equity quite a bit, yet it costs the company nothing. One secret to Sam Walton's success at Walmart was selling Tide detergent before having to pay the bill to Procter & Gamble. in effect, he was using P&G's money to grow his retail enterprise.

Policyholder "Float"

Used by insurance companies, this is money that doesn't belong to the firm. It can be used or earn interest until it has to pay it out.

Seeking the Optimal Capital Structure

Many middle-class investors have a goal of being debt-free. When it comes to a business's capital structure, there is more to it.

Many of the most successful companies in the world base their capital structures on one simple consideration—the cost of capital. The so-called DuPont model can offer further insight.

Suppose you can borrow money at 7% for 30 years. The rate of inflation is 3%. You can reinvest that money in core operations at a 15% return, That is a reason to go into debt. It would be wise for your overall capital structure to contain at least 40% to 50% in debt capital, especially if your sales and cost structure are pretty stable.

If you sell an essential product, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a booming market. This is where managerial talent, experience, and wisdom come into play.

The best managers have a knack for consistently lowering their weighted-average cost of capital by increasing productivity, seeking out higher-return products, leveraging debt wisely, and more.