Capital structure: Overview, definition, and example
What is capital structure?
Capital structure refers to the way a company finances its operations and growth through different sources of funds, primarily equity (ownership capital) and debt (borrowed funds). The capital structure represents the balance between a company’s equity and debt, which determines its financial leverage, risk, and cost of capital.
Equity typically includes common stock, preferred stock, and retained earnings, representing ownership in the company. Debt can include loans, bonds, and other forms of borrowing, which the company must repay with interest. The specific mix of debt and equity in the capital structure influences the company’s financial stability, flexibility, and growth potential.
Why is capital structure important?
Capital structure is important because it directly impacts a company’s financial performance, risk profile, and valuation. The right balance between debt and equity can lower the cost of capital, increase returns to shareholders, and provide greater financial flexibility for the company’s operations and investments.
For companies, managing the capital structure is crucial in maintaining an optimal balance of risk and return. Too much debt increases financial risk due to interest payments and potential default, while too little debt may result in missed growth opportunities or underutilization of financial leverage. For investors and stakeholders, the capital structure provides insight into the company’s risk level, profitability, and long-term viability.
Understanding capital structure through an example
Imagine a technology startup that decides to raise capital to fund its expansion. The company may choose to raise funds through equity financing by selling shares of stock, thus giving investors ownership stakes in the company. Alternatively, the company might opt for debt financing by taking out a loan or issuing bonds, which it will need to repay over time with interest.
The company’s capital structure could then be a mix of both equity and debt. For example, if the startup raises $2 million in equity and $3 million in debt, its capital structure is 40% equity and 60% debt. The balance between these two sources of capital will affect the company's risk, cost of financing, and future financial strategy.
In another example, a well-established manufacturing company may have a more stable capital structure, with a lower proportion of debt relative to equity. This can be due to its ability to generate consistent cash flow and its preference for maintaining a lower financial risk profile. For this company, the capital structure may be 70% equity and 30% debt.
An example of a capital structure clause
Here’s how a capital structure clause might look in a financial agreement or company policy:
“The Company’s capital structure shall consist of no more than [Insert Percentage]% debt and [Insert Percentage]% equity. The Company agrees to maintain a debt-to-equity ratio within the agreed range to ensure financial stability and optimize the cost of capital. Any material changes to the capital structure shall require approval by the Board of Directors.”
Conclusion
Capital structure plays a fundamental role in shaping a company's financial strategy and operations. It influences the company's risk profile, cost of capital, and its ability to grow and manage financial obligations. The right mix of debt and equity is critical for maintaining a company’s financial health and maximizing shareholder value. Both businesses and investors must carefully consider the capital structure when making decisions about funding, growth, and long-term viability.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.