Company capital structure: Overview, definition, and example
What is company capital structure?
Company capital structure refers to the way a company finances its overall operations and growth by using a combination of debt (borrowed funds) and equity (owner-invested funds). It represents the proportion of various sources of capital used by a company to fund its business activities, such as loans, bonds, preferred stock, and common equity. The capital structure is a key factor in determining a company’s financial stability, risk profile, and ability to raise additional capital.
The capital structure helps businesses decide how to finance their projects and operations, balancing between debt and equity to optimize profitability while managing financial risk.
Why is company capital structure important?
The capital structure is important because it affects a company’s risk, financial flexibility, and cost of capital. The choice between debt and equity financing can influence the company’s financial health, profitability, and long-term growth. A company with too much debt may face higher interest costs and increased financial risk, while a company relying too heavily on equity may dilute ownership and control.
For businesses, an optimal capital structure allows for efficient growth and investment, minimizes the cost of capital, and ensures that the company can weather financial challenges. It also has tax implications, as interest on debt is generally tax-deductible, whereas equity financing does not provide such benefits.
Understanding company capital structure through an example
Imagine a company, Company A, that is looking to expand its operations. The company can finance the expansion in two main ways: through debt or equity.
- Debt Financing: Company A may choose to take out a loan or issue bonds to raise funds. For example, if the company borrows $1 million in the form of a bond, it will incur interest payments over the loan's life.
- Equity Financing: Alternatively, Company A could issue additional shares of stock to raise $1 million. In this case, new shareholders would own part of the company, and there would be no interest payments required, but the ownership of the company would be diluted.
Company A’s capital structure might be composed of 60% equity and 40% debt. The mix will determine the company’s financial risk, cost of capital, and growth opportunities.
Example of a company capital structure clause
Here’s how a capital structure clause might appear in a company’s corporate governance document or financing agreement:
“The Company shall maintain a capital structure consisting of no more than 50% debt to total capital ratio, with the remaining 50% financed through equity. Any significant change in this ratio, including new debt issuances or equity offerings, must be approved by the Board of Directors.”
Conclusion
Company capital structure is a fundamental element of financial strategy that determines how a company funds its operations and growth. The right mix of debt and equity can help a company optimize its cost of capital, manage risk, and achieve its long-term goals. Understanding and managing capital structure is essential for business owners, managers, and investors to ensure the financial health and stability of the company.
For business owners, determining the ideal capital structure involves balancing between the benefits of debt financing (lower cost of capital) and equity financing (maintaining control and avoiding financial risk). Monitoring and adjusting the capital structure over time ensures that the company remains competitive and financially viable.
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.