What Capital Structure Is and How It Works

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Lauren Ward

Updated June 6, 2021

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What Capital Structure Is and How It Works; Capital structure is important for any size of business.

Whether you’re the CEO, a shareholder, or a potential investor, there are a lot of financial terms to track when you're evaluating a business. Capital structure is one of these important concepts. It’s a key metric to understand and be able to evaluate because it shows how much debt a company has leveraged in relation to the amount of equity held.

What Is Capital Structure?

Capital structure refers to a financial ratio that shows a business’s debt versus its equity. It’s an important component of cash management and can help the business make decisions about the best way to fund future capital needs. Types of debt included in capital structure:

Long-term debt: Usually debts held for at least 12 months, which may include bonds, lines of credit, and bank loans
Short-term liabilities: Debts scheduled to be paid off in the next year or less, which may include short-term bank loans and commercial paper

Types of equity included in capital structure:

Common equity: Stock owned by founders and (if applicable) employees
Preferred equity: Stock owned externally. Preferred stockholders are in a higher tier than common stockholders when it comes to claiming dividends or assets

The debt-to-equity ratio is important for the business itself, as well as for investors and potential lenders. It helps them all gain an accurate picture of how the company funds its operations and what the consequences are. Debt must be paid back to the lender but it doesn’t change the current ownership. Equity, on the other hand, impacts the ownership structure of the business but doesn’t need to be repaid. There’s no right or wrong capital structure. A healthy capital structure ratio depends on the needs and goals of each individual business.

Types of Capitalization Structures

There are basically two different types of capitalization structures: high leverage and low leverage. Which type your company has depends on how much debt it carries versus its shareholders’ equity. Each type of capitalization structure has its own pros and cons.

High Leverage

With a high leverage capitalization structure, a business uses more debt than equity to fund its operations and growth. Industries like insurance and banking may be highly leveraged. Companies that are highly leveraged may be more appealing to investors eager for high returns and willing to accept a higher risk level. This is considered an aggressive form of cash flow and has both advantages and disadvantages.Pros

Tends to cost owners less than equity
Fixed repayment schedule
Maintains current ownership of company

Cons

Lower revenue could diminish company profitability
Too much debt leads to risk of default
Has to be paid back, as opposed to equity

Low Leverage

A lower level of debt may seem healthier but can come with some drawbacks as well. While your business may be more stable, you may miss potential growth opportunities. But this structure may be appealing to cyclical industries, like mining, which have uneven cash flow. Investors looking for slow and steady lower-risk opportunities may prefer this kind of capital structure. Pros

Greater financial stability
No fixed payments
Operational flexibility

Cons

Could hinder growth
Owner loses some degree of ownership and control
Paying dividends can eat into profits

How to Calculate Capital Structure

Calculating the capital structure of a company is simple using the debt-to-equity ratio. This information is easy to find on the company balance sheet.

First, add up all of the outstanding debt.
Then add up the total amount of capital from equity sources.
Finally, divide the debt by the equity to find the ratio.

For instance, let’s say a hypothetical company has $500,000 in debt. Its equity is determined by subtracting the amount of liability from its assets. Let’s say assets total $750,000 and we subtract the $500,000 debt to reveal $250,000 in equity.By dividing $500,000 (debt) by $250,000 (equity) we find that the debt is 2X higher than equity. For every $1 the company has in equity, it has $2 in debt—meaning that the company is leveraged quite extensively. These numbers can also be used to find the company’s cost of capital, which is used to determine how quickly a profit can be made from an upfront investment.

What Is the Best Capital Structure?

An ideal capital structure may be different for different companies. As a general rule of thumb, there should be a balance between risk and caution. A business with a low leverage ratio may miss out on growth opportunities. So while there may not be a lot of debt tied to the company, there is the risk of stagnation and being outpaced by competitors.On the other hand, a highly leveraged company may barely be meeting its payments. Any revenue figures that come in under the projected numbers could cause major cash flow issues. The advantage, of course, would come if the gamble did pay off. Successfully investing in growth opportunities could lead to better revenue and profit margins.One measurable way to find a business’s best capital structure is to calculate its weighted average cost of capital (WACC). This formula identifies the average cost of multiple capital sources, including debt, stocks, and bonds. The benefit of using this metric is that it helps to quantify the cost of selling equity, even though it’s used differently than debt.Ultimately, there are multiple factors that affect the level of risk and reward associated with your company’s capital structure. When determining your business’s best capital structure, you may want to consider not only measurable formulas, but also the strength of your team and the forecasts for your industry.

What Is Recapitalizing?

Recapitalizing means changing the makeup of your business’s capital structure. Essentially, it entails either increasing or decreasing the company’s leverage. The goal is usually to provide more financial stability within the company. There are two major ways to recapitalize a business.

Reduce Debt

If a business is highly leveraged, it might pay off debt in order to reduce the payments it has to make and increase the amount of equity in the company. This can improve cash flow and liquidity. It can also improve profits. For public companies, that increases earnings per share (EPS). In some cases, a business may also reduce debt by opting for a debt/equity swap, in which a creditor accepts equity (such as bonds for a publicly traded company) as payment.

Increase Debt

The opposite recapitalization strategy is to increase debt to achieve one or more goals. Using debt interest as a tax deduction could actually result in better tax savings. Because debt comes with strict payment schedules, it can be used to improve operational efficiency. In a risky environment, higher levels of debt could also be taken on to deter potential takeovers. Recapitalization is often used to make major changes in a business. Changing the balance between debt and equity can be an effective tool in restructuring your business’s existing capital structure to achieve specific goals.

The Takeaway

Capital structure is an important metric for companies of all sizes, from small businesses to those that are publicly traded. Your company’s existing capital structure demonstrates the balance between debt and equity, which can also help you make more informed decisions about how to finance new growth. You may decide to maintain your company’s balance between debt and equity, or you might choose to recapitalize if you have specific goals you feel your current capital structure isn’t helping with.If your small business is considering adding debt to your capital structure, you can benefit from comparing multiple lenders together to see the relative benefits and drawbacks of each. Compare small business lenders today and find out if a small business loan or line of credit could help your company.

This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice. SOLC21015

About the Author

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.

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