written by | June 2, 2022

What Is Capital Structure? Types & Measuring Methods Explained

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You may be wondering, "What is Capital Structure?" You may be curious about the benefits and disadvantages of a company's debt structure and how analysts and investors evaluate it.

Economists define "capital" as a form of wealth that can be used to create wealth. Businessmen often use the word to describe the total assets used in the business. The accountant uses the term to refer to net assets or stockholders' interests as indicated by the balance sheet or the net worth of equity of the stockholders. In law, capital means capital stock.

This article will explain why different companies have different capital structures, how managers decide how to structure the company's debt and equity, and how analysts and investors evaluate this key measurement. Read on to learn more about this important aspect of corporate finance.

Did You Know?

It is helpful to determine the riskiness of a company’s borrowing habits by using the debt-to-equity ratio (D/E). The goal of management is to find the optimal mix of equity and debt, also known as the optimal financial structure to finance operations.

Also Read: What Are Leverage Ratios? - Types, Formula, How to Calculate

Understanding Capital Structure

The first step is to find the answer to what is capital structure. If you want to understand how to interpret a capital structure, you must understand what it represents. Capital structure refers to the mix of debt and equity used to finance a business. 

It relates to the costs of each type of debt and equity. Debt is often associated with a higher risk than equity, so it's important to know the details of both forms. This information is key in determining its growth strategy and predicting its performance.

What Are Various Types of Capital Structures?

Now that you know capital structure meaning let’s know its types. There are different types of capital structures, and the most common are the two types - Debt and Equity. 

Which one is right for your company? Make sure to read this article to learn how to make the most efficient capital structure for your company. You'll want to start by identifying the main differences between these types of capital. Using a mix of all will maximise your chances of success.

 

  • Debt Capital

Debt Capital Structure data provides a detailed analysis of a company's debt sources for both public and private companies. The DCS data is derived from financial tables of actual company filings and accounts for the full range of debt instruments, including cash and equity. 

The DCS data also includes short-term credit facilities, swaps and more coverage. The data allows users to review debt instruments by their ultimate issuer and immediate parent company, enabling them to spot the patterns and trends in the structure over time.

  • Financial Leverage

The term is used to describe the amount of debt that forms an integral component of the company's entire capital. The name capital gearing also knows it. A company with high debt levels is said to be a highly leveraged business, while one with a low proportion of debt is a lower levered company.

  • Equity Capital

The capital structure is composed of two main components: debt and equity. In a company, equity capital comes from ownership of shares and claims on future cash flows. While debt typically consists of loans and bonds, equity may consist of common stock, preferred stock, retained earnings and even short-term loans. While debt is money borrowed by a company, equity does not have to be repaid.

  • Optimal Capital Structure

The optimal capital structure is a critical part of financial management, and it allows a firm to raise funds from various sources at the lowest cost possible. 

This type of capital structure is calculated by calculating the present value of future cash flows discounted by the weighted average cost of capital, or WACC. In other words, it creates a balance between equity and debt. However, the optimal capital structure depends on a company's particular needs.

Why Do Different Companies Have Different Capital Structures?

If a business uses just the current liabilities, like long-term loans or supplier credit, to fund its business, its cost of capital will be based on the interest rate it pays on the debt. If a business is publicly traded with investors, the cost of capital is more complex. 

The key factors affecting capital structure include industry leverage, growth opportunities, asset tangibility, expected inflation, profitability, firm size and stock market return. When comparing the capital structures of different companies, it's important to understand the differences between these capital types. 

The most beneficial type for a company depends on its payback priority. Generally, a higher payback priority means lower risk, making it more attractive to invest in new projects. A company's capital structure reflects how it funds its operations. There are different types of debt, such as long-term debt, specific short-term liabilities and preferred stock. 

Combining these types of financing can impact a company's bottom line. It's important to understand what each type of capital structure means. The optimal capital structure is the one that maximises a company's total valuation and minimises the costs of capital. Ideally, a company should have a balance between debt and equity and balance the risks and benefits of each. 

When considering the best capital structure, you need to consider the company's life cycle, its free cash flow profile and the market conditions. The capital structure of a company is critical to its success.

The optimal capital structure combines debt and equity, and the optimal balance between these sources is called capital equilibrium. Different companies have different capital structures, so it is crucial to understand how they work and what works best for each.

Also Read: Difference Between Fixed Capital and Working Capital

How Do Managers Decide on the Capital Structure of a Company?

A company's capital structure refers to the sources of financing the firm uses to fund its operations. Most companies use a combination of short-term and long-term debt and equity (such as common stock or preferred stock) to finance their business operations.

Although this can pose a risk to investors, it can also provide a company with growth potential. Managers must balance these competing goals when deciding on a company's capital structure.

While there is no perfect science to determine the optimal capital structure, there are some guidelines for making the right decision. Many managements take various factors into account when making a capital structure decision, including the amount of debt needed, debt cost and investment return. The first step is evaluating the firm's capital requirements. 

Companies need capital to finance operations, organic growth, acquisitions and returning cash to shareholders. A company's capital structure will ultimately determine its performance. A capital structure that is too reliant on the debt will leave less cash available for management compensation and free cash.

How Do Analysts and Investors Use Capital Structure?

Capital structure is an important factor in gauging a company's potential. Companies with too much debt and too little equity will usually not provide the best returns for investors.

This is because debt typically costs more than returns on shares, and interest income is taxed more heavily. The right balance of debt and equity will depend on a company's industry, development stage, and strategy. Capital structure can also change due to changes in interest rates or other external factors.

When comparing capital structures, analysts and investors look at the debt to equity ratio. An excessively high debt to equity ratio could mean a company is not using its growth potential and is paying too much for capital. 

However, it's important to remember that there is no magic formula for optimal capital structure. It can vary depending on the industry, stage of development and external changes in interest rates and regulatory environment.

By calculating the debt/equity ratio, analysts can determine a company's capital structure and assess how it will affect its profitability.

What Measures Do Analysts and Investors Use to Evaluate Capital Structure?

Measure 1

There are several measures analysts and investors use to evaluate the capital structure. A debt-to-equity ratio is one of them, and the ratio tells investors how much debt the company has compared to its total equity. 

While this ratio is useful in determining the level of debt in a company, it can also provide clues about its risk management practices. Heavily financed companies are often riskier than companies that use a smaller ratio. However, such high ratios can indicate a company's growth potential.

Measure 2

Another way analysts and investors evaluate capital structure is by looking at the ratio between debt and equity on a company's balance sheet. In general, lower debt levels are more attractive than higher equity levels, and credit agencies use this ratio to determine the quality of a company's capital structure. 

Debt and equity ratios: A balance sheet's cash-to-debt ratio can tell investors whether a company's debt is too high or too low. However, these ratios can be misleading, and it's important to note that they differ in investor risk aversion. In addition, debt-to-equity ratios are also important to investors, as they reflect a company's risk level.

Measure 3

Liquidity ratios show how much cash a company has on hand to meet its short-term obligations. They compare a company's current assets with its current liabilities. The key is to determine whether the company has enough cash on hand to meet its obligations but not too much that it won't be able to make payments. Net debt ratios are widely used in credit analysis, and the quick and current ratios are the most common.

Measure 4

The weighted average cost of capital is another important measure to consider. In this measure, the cost of debt to equity is multiplied by the proportion of each capital component. When evaluating capital structure, it is best to understand how it works. In general, the higher the ratio, the higher the risk is for the company. However, if the ratio is too high, the risk for investors is higher.

Conclusion

The capital structure consists of equity and debt securities, which are a company's financing of its assets. The company's long-term financing is represented by long-term loans, along with preferred stocks and net worth.

Hope everything related to the capital structure is clear now, and if not, please drop comments below. If you want to manage your capital structure better, it's essential to keep track of profit and loss ratios. Therefore, signing up for a  platform like Khatabook can be ideal.

Now keep track of your cash flow and manage your incomes and expenses with ease by using the Cashbook app by Khatabook.

FAQs

Q: What Are Various Types of Capital Structure?

Ans:

The four  types of capital are:

  • Working capital
  • Debt
  • Equity
  • Trading capital 

Q: What About Factors Determining Capital Structure?

Ans:

Following are the factors of capital structure:

  • Trading on Equity
  • Degree of control
  • Flexibility of financial plan
  • Choice of investors
  • Capital market condition
  • Period of financing
  • Cost of financing
  • Stability of sales
  • Sizes of a company

Q: What Elements Form the Capital Structure of a Company?

Ans:

Capital Structure is the amount of money that's invested in a company. It consists of Equity Capital, Net Worth, Total Borrowing and Reserves and Surplus.

Q: What Is Capital Structure?

Ans:

Capital structure is the combination of equity and debt a company uses for its overall growth and operations. Equity capital is derived from ownership shares and claims to future profits and cash flows.

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The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.
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Disclaimer :
The information, product and services provided on this website are provided on an “as is” and “as available” basis without any warranty or representation, express or implied. Khatabook Blogs are meant purely for educational discussion of financial products and services. Khatabook does not make a guarantee that the service will meet your requirements, or that it will be uninterrupted, timely and secure, and that errors, if any, will be corrected. The material and information contained herein is for general information purposes only. Consult a professional before relying on the information to make any legal, financial or business decisions. Use this information strictly at your own risk. Khatabook will not be liable for any false, inaccurate or incomplete information present on the website. Although every effort is made to ensure that the information contained in this website is updated, relevant and accurate, Khatabook makes no guarantees about the completeness, reliability, accuracy, suitability or availability with respect to the website or the information, product, services or related graphics contained on the website for any purpose. Khatabook will not be liable for the website being temporarily unavailable, due to any technical issues or otherwise, beyond its control and for any loss or damage suffered as a result of the use of or access to, or inability to use or access to this website whatsoever.