In Finance, what is Capital Structure?

Geri Terzo
Geri Terzo
Man climbing a rope
Man climbing a rope

A company's capital structure refers to its debt level relative to equity on the balance sheet. It is a snapshot of the amount and types of capital that a firm has access to, and what financing methods it has used to conduct growth initiatives such as research and development or acquiring assets. The more debt that a firm carries, the more risk it is perceived to carry. An ideal capital structure represents a balance of debt and equity on a balance sheet.

There are various types of equity and debt that constitute a capital structure. Typically, the components that make up these two asset classes are bonds, preferred stock, and common stock. Bonds are a form of debt, and include loans that a company takes out with a financial institution or with investors. Debt is also considered leverage, and when a company has too much debt on its balance sheet, it is said to be over-levered.

On the equity side, common stock is the amount of shares held by common shareholders. These stockholders own an equity stake in the business and obtain voting rights for important company events. Preferred shareholders similarly obtain an equity stake in the business, but are not entitled to vote.

A preferred investor receives ongoing dividend payments from a company's net income, or profits, as do some common shareholders. Profits that a company does not distribute to shareholders through dividend payments but instead are reserved are known as retained earnings, and qualify as equity on a company's balance sheet. Any additional capital earned from a stock offering similarly adds to equity.

Capital structure is what a company relies on to acquire the assets necessary to generate future sales and profits at the firm. In order for the financial capital structure to work efficiently, it will generate returns from the equity and debt that are higher than the cost of servicing that debt and equity. Costs associated with servicing debt and equity may include interest and principal payments to bondholders and dividend payments to shareholders.

Issuing debt tends to be a cheaper form of financing for companies versus equity issuance. Although debt holders are entitled to ongoing payments tied to a loan, the expectations for returns are not as high as they are for equity investors. This is because equity holders are taking more of a risk than debt holders. Therefore, the burden is on a company to constantly grow earnings and the stock price in order to retain equity shareholders. In the event of a bankruptcy, bondholders receive priority for a company's assets over equity holders.

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