Decoding Capital Structure: How Companies Finance Their Growth

Every business needs capital to thrive, yet many struggle to strike the right balance between debt and equity. 

Understanding this balance is crucial for a firm to maintain financial health; failing to do so can jeopardize stability and hinder growth.

To tackle the complexities of capital structure management, businesses can turn to accounting software. This powerful tool streamlines the management of capital sources, including banknotes, long-term debt, common equity, and preferred equity.

By examining the intricacies of capital structure, we can uncover how businesses strategically allocate resources, manage financial risks, and optimize their capital for sustainable growth.

Importance of capital structure

Every business has different capital structure needs, depending on their cash flow and financial support requirements. For example, a consumer goods company may have lower capitalization needs than a travel firm that has higher cash flow demands because of seasonal spikes. That’s why proprietors and enterprises use distinct risk analysis and debt management methods to effectively shape their liquidity and capital structure.

An optimal capital structure helps companies limit liabilities, keep debt earnings and retained earnings in check, and maximize cash flow. 

What is an optimal capital structure?

An optimal capital structure is the best debt and equity mix that gets you the most out of your company’s market value while cutting the cost of capital. Companies generally achieve the lowest cost mix of financing by minimizing the weighted average of cost of capital (WACC).

Considerations that impact a firm’s operating capital structure decisions include:

• Company characteristics, such as company’s business model, maturity, and operations.
• Capital structure policies guiding a firm’s borrowing limits based on its risk appetite and debt paying abilities.
• Market conditions, including interest rates and share price levels.

A capital structure isn’t always the result of management decisions. Companies can be in financial distress because of unmanageable debt or aggressive capital structure policy. Changes in the market value of company securities can also affect a firm’s capital structure. 

Types of capital structure

Companies use different forms of debt and equity capital to form their capital structure.

Debt capital

When one party owes money to another, the former party is in debt. While the layman might think of being in debt as a bad thing, business owners and company officials who are concerned with capital structure know that debt capital is a powerful way to leverage company growth. Companies classify its debt as a liability—they must budget to pay it back. There are several strategies and devices to do this with, each is unique, with its own benefits and drawbacks.

Leverage ratio

Companies often track their leverage ratio—how much debt they hold relative to their equity—to assess financial health and avoid over-leveraging. High levels of debt can lead to greater risk, especially if a company struggles to make interest payments.

Apple, for instance, has leveraged corporate bonds even though it holds massive cash reserves. The company takes advantage of low-interest rates to borrow and fund share buybacks or dividends, showing how even profitable companies use debt strategically.

Business loans

A tried and true method of debt financing is through business loans, especially in small business finance. Options include term loans, small business administration (SBA) loans, bank lines of credit, and more. There is a type of loan out there to suit just about any business’s specific needs.

Notes payable

Notes payable are another sort of lending agreement, except instead of borrowing money from a bank, companies use them to borrow money from elsewhere, like from investors or even friends and family. They use promissory notes to mediate these kinds of lending agreements.

Corporate bonds

More established companies issue corporate bonds as a means of generating debt capital. Like all forms of debt capital, bonds are also lending agreements, but they can be bought and sold on the secondary market and are classified by term length. Some bonds have provisions that make them more or less appealing to investors.

 Amazon’s $10 billion bond issue in 2023 to fund its sustainability initiatives highlights how large companies use bonds to support specific goals.

A bond with a sinking fund, for example, is a less risky investment. Some companies may issue convertible bonds—debt investments that can be converted into company shares, or equity. Once this type of bond is converted, it is no longer part of a company’s debt financing but is accounted for as equity financing.

Equity capital

Debt is fairly easy to understand—borrow something from someone else, and you’re in debt. Financing with debt means a company has an obligation to pay lenders back, financing with equity means that a company gives up part of ownership in exchange for equity capital. How do companies manage to do this? By selling stock.

Stock

Stock is the main type of equity financing, unlike the forms of debt financing we learned about above, when issuing stock, a company gives up some ownership in exchange for capital. Each stock share in a company represents an equal amount of equity in that company.

Just like there are countless types of bonds and loans, there are also different kinds of stock. Common stock grants shareholders voting rights, while preferred stock earns fixed dividends or periodic payments from the company. Stock can also come in the form of stock options or stock offered to employees at a lower price than the public rate or even before a company’s initial public offering (IPO).

Stock comes in several varieties:

• Common stock: Common shareholders typically have voting rights but are last in line to receive payouts in the event of liquidation.
• Preferred stock: Preferred shareholders receive fixed dividends and are prioritized over common stockholders for dividend payments, making preferred stock a safer investment during financially volatile periods.
• Employee stock options: Offering stock options to employees helps align their interests with the company’s success. Many tech startups use stock options as part of their compensation package to attract and retain top talent.

Retained earnings

Retained earnings, or profits a company has earned and saved over a period of time, can be reinvested to fund company operations and growth. Think of them like a company’s savings account. They are considered part of a company’s equity in capital structure.

Dynamics of debt and equity

Debt investors often accept lower rates of return because they can make the first claim on business assets in case of bankruptcy. That’s why firms enjoy a lower cost of capital while issuing debts.

On the other hand, equity investors receive the residual value after a business repays the debt. They expect a higher rate of return as they take more risk. As a result, the implied cost of equity exceeds that of debt. 

Business owners and managers always have to consider these tradeoffs between debt and equity while managing business capital structure. 

How to analyze capital structure

You now know the elements that make up debt and equity in the capital structure of a company. But how can you tell if they have an optimal balance of each? Let's understand the steps. 

1. Reviewing the balance sheet

The first step in capital structure analysis is examining a company's balance sheet, which outlines its total liabilities (debt) and shareholders equity. This snapshot shows the proportion of debt and equity financing and helps assess the company’s reliance on borrowing versus internal resources.

2. Weighted average cost of capital (WACC)

One of the most critical tools for evaluating capital structure is the weighted average cost of capital (WACC). This metric helps measure the company’s overall cost of financing its operations, factoring in both debt and equity. A lower WACC means the company can finance its activities more cheaply, making it more efficient and attractive to investors.

WACC takes into account:

• Cost of debt (the interest paid on loans and bonds, adjusted for tax benefits)
• Cost of equity (the expected returns shareholders demand)
• The proportions of debt and equity in the company’s capital structure.

Calculating the WACC allows investors and analysts to compare it against the company's return on investment to determine whether it is effectively using its capital to generate growth.

3. Debt-to-equity ratio

The debt-to-equity ratio is a simple yet powerful tool for assessing capital structure. It compares a company’s total debt to its total equity, providing a clear picture of how much leverage the company uses.

A higher debt-to-equity ratio signals that the company relies more on debt, which may increase financial risk, especially if cash flows are volatile. For example, a debt-to-equity ratio of 2:1 means that for every $1 of equity, the company has $2 of debt. This might be acceptable in capital-intensive industries, but in others, it could raise concerns about excessive leverage.

4. Debt ratio

The debt ratio measures the proportion of a company’s assets that are financed through debt. It is calculated by dividing total liabilities by total assets. A high debt ratio suggests that a company relies heavily on borrowing to fund its assets, which can be risky in times of economic downturn or when cash flows are strained.

5. Equity ratio

The equity ratio represents the portion of a company’s assets financed by shareholders' equity. It is calculated by dividing total equity by total assets. A higher equity ratio indicates a more conservative capital structure with less reliance on debt. This may be viewed as a safer investment but could limit the company’s growth potential if it's not leveraging debt efficiently.

6. Capitalization ratio

The capitalization ratio assesses the proportion of long-term debt compared to the total capital (long-term debt + equity). It reflects how much of a company’s capital comes from debt, providing insight into its long-term financial strategy. A high capitalization ratio may indicate potential solvency issues, while a low ratio suggests financial stability but possibly conservative growth.

7. Interest coverage ratio

The interest coverage ratio measures a company's ability to meet its debt obligations by comparing its earnings before interest and taxes (EBIT) to its interest expenses. A higher ratio indicates that the company generates enough earnings to comfortably cover its interest payments. A lower ratio might signal that the company is at risk of defaulting on its debt.

So, let's take the example of a company that has historically balanced high levels of debt with strong equity financing, relying on significant shareholder investment to fuel its growth. By monitoring it's debt-to-equity ratio and WACC, investors can assess whether the company is optimally leveraging its capital to scale its business while managing risks.

Is it structurally sound?

Now that you know what makes up capital structure and how to analyze it, you can use it to gain extra insight into a company's inner workings. Capital structure is one of the most important concepts in finance and is useful for both company finance officials and outside investors.

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This article was originally published in 2019. It has been updated with new information.