At a glance, it can be tough to tell whether a building is structurally sound based on its outside appearance.
Broken windows and peeling paint can be indicators, but the signs are not always outwardly apparent. Only once the building is inspected from the inside out can it be deemed structurally sound. The same can be said about the capital structure of a company.
What is capital structure?
Capital structure is the way a company finances itself through a mixture of debt and equity. An optimal capital structure maximizes growth while minimizing the risk of bankruptcy.
There are several helpful financial ratios that can help illustrate what a company’s capital structure looks like, but before diving into capital structure analysis, make sure you have a solid understanding of its two components: debt and equity.
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.
A tried and true method of debt financing is through business loans, especially in small business finance. Options include term loans, 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 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.
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. 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.
Debt is fairly easy to understand—borrow something from someone else, and you’re in debt. But what is equity? Here’s a simple way to think about it: 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 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 lower than the public rate, or even before a company’s IPO (that is, before it offers shares up for sale to the public).
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.
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? Your first step would be looking at the company’s balance sheet where you can find information about how much debt and equity it has.
Then you would apply that information to a financial ratio to analyze how optimal that company’s capital structure is compared to its peers and industry leaders. WACC, or weighted average cost of capital, is the standard way to determine this.
WACC (Weighted average cost of capital)
WACC is a formula that tells you how quickly a company is able to use its capital to finance business and growth. The lower the WACC, the better. This is the primary formula used to determine the optimization of a company’s capital structure. You find it using a company's cost of debt and equity, percentage of debt and equity, and tax rates.
Other ratios like debt ratio, equity ratio, capitalization ratio, debt to equity ratio each provide a unique insight into a company’s capital structure. Use them to determine whether or not to invest in, work for, or generally associate with a company.
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 the inner workings of a company. Capital structure is one of the most important concepts in finance and useful to keep in mind for both company finance officials and outside investors alike. Business finance services can calculate WACC and other ratios for you, helping you keep track of your company’s capital structure.