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November 1, 2021

Business

The Importance of Capital Structure

What is Capital Structure?

Capital structure relates to how much money—or capital—is supporting a business, financing its assets, and funding its operations. It can also show company acquisitions and capital expenditures that can influence the business’s bottom line. Capital structure is an important term to understand, especially for those who want to advance their business careers and for financial analysts.

How capital in a company is managed can differ based on what kind of capital it is. The two most important kinds of capital are debt capital and equity capital. Businesses need to show shareholders, investors, and others that they have a solid debt-to-equity or debt-to-capital ratio to encourage more support of the company—financially or otherwise. In some instances, companies may incur debt to finance their operations. But if a company has too much debt, they may be deemed too risky with not enough reward for investors to offer more financial backing.

Although it can vary by industry, capital structure is important to businesses of all kinds, from small businesses managing their start-up finances, to large international companies managing their funds with an eye on expansion. Each business should make sure that they're using the optimal capital structure for their business and industry.

Let’s look at the different kinds of capital structure and why they’re important.

What is Equity Capital?

Equity capital is a principal of corporate finance, largely considered to be debt-free capital that can come from a variety of places, such as stock options, savings, company earnings, or even family investments. The different components of equity in company capital structure include:

  • Hybrid Financing: A mix of equity and debt found in publicly traded companies, often bought and sold via brokerage firms.
  • Convertible Equity: Hybrid financing that may be offered via convertible preferred shares that can convert to common shares at a fixed rate.
  • Preferred Equity: Financing based on a degree of ownership interest in a business or company, which has its pros and cons, such as payouts before other stockholders but not including any voting rights.
  • Common Equity: Another form of financing offering ownership interest, although ownership doesn’t happen until after the business or company pays off its debts—which makes it a higher risk.

Contributed Capital

When a company receives an investment in exchange for stock, this is contributed capital. This is often what’s offered to venture capitalists and other first-round investors, such as angel investors. Shareholders may also fall under this category. Companies or business owners often have to relinquish their complete control over their businesses in exchange for this kind of funding.

Retained Earnings

Companies can also use their earnings from previous years to fund their businesses, fuel expansion, or assist with acquisitions. This kind of funding works well for larger businesses with brand recognition, as they don’t have to work as hard to convince investors to support the business by buying stock. But green or start-up businesses will need to show a higher return to entice those same investors.

Hand reaching to catch dollar sign

What is Debt Capital?

Debt capital is money that has been borrowed to help support a business’ capital structure. This money may be borrowed over either short term or longer term periods. How much it costs the company is dictated by their viability; if they’re highly rated and able to borrow with low rates, it looks better for a company than if their risk dictates a higher percentage rate on what they borrow. This is where the company balance sheet becomes key to showcasing their worth to lenders and investors.

The different components of debt in capital structure include:

  • Senior Debt: If a company faces financial trouble or filed for bankruptcy, financing under this category gets paid back first. Senior debt loans tend to have a lower interest rate.
  • Subordinated Debt: These loans aren’t as risk free as senior debt loans, but their higher interest rates mean lenders can make their money back and then some.
  • Mezzanine Debt: A subcategory of subordinated debt, mezzanine debt tends to carry higher interest rates because of their reliance on both equity and debt for funding.
  • Hybrid Financing: Another form of debt that relies on both equity and debt that pays interest or dividends, offers fixed or floating returns, and are bought and sold by brokers.
  • Convertible Debt: This debt that comes in the form of bonds can be converted to equity based on a predetermined amount as decided by the debtor.

Loans or Credit Cards

Countless companies have an origin story with a historical capital structure that includes financing from family members, maxed out credit cards, or both. It may not be the easiest way to build company capital structure, which is why loans or small business funds can be a less complicated option—although the application process may be more involved, requiring a business plan and an outline of expenses.

Long-Term Bonds

This debt is a small business’s dream come true because it only pays interest, and the principal doesn’t have to be paid off for a long time.

Short-Term Commercial Paper

These 24-hour loans can account for billions of dollars borrowed from the capital markets, often used by larger Fortune 500 companies to cover major operating costs.

Vendor Financing

Companies may turn to this form of debt to cover any bills owed to vendors, selling off goods to build their business while satisfying financial partners.

Policy Holder “Float”

Insurance companies rely on this kind of debt to cover costs as needed or sit in an account and earn interest until the debt needs to be repaid.

The Importance of Finding the Right Capital Structure for a Business

Every business has different needs, especially when it comes to capital structure. The cash flow and financial support requirements for an international conglomerate are likely going to be more involved and complicated than that of a mom n’ pop shop. Similarly, the capitalization needs of a company focused on consumer goods, which may carry a lower risk, will vary in comparison to a travel company, where needs and demands ebb and flow with the seasons. But both businesses still need to determine what kind of capital structure is going to help them be successful and meet their goals.

Risk analysis and debt management will also operate differently for business entities versus individual proprietors, which is a key component to determining capital structure development and management. By starting out with a strong foundation that limits liabilities, maximizes cash flow, and keeps an eye on the proportion of debt and retained earnings, businesses can create an optimal capital structure that will support their efforts—and encourage others’ support—for years to come.

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