The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowments from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Aspect
Explanation
Capital Structure
Capital Structure refers to the composition of a company’s capital, including its mix of debt and equity used to finance its operations and growth. It’s a crucial aspect of financial management and impacts a firm’s financial health and risk profile.
Debt Financing
Debt in the capital structure represents funds borrowed by the company, typically through loans or bonds. Using debt can provide tax benefits, but it also creates financial obligations, including interest payments and repayment of principal.
Equity Financing
Equity includes funds raised through the sale of company shares, making investors partial owners. Equity financing doesn’t involve debt obligations, but it dilutes ownership and may lead to sharing company profits with shareholders.
Financial Leverage
The use of debt in the capital structure is known as financial leverage. It can amplify returns when the return on assets exceeds the cost of debt, but it also increases financial risk because of the fixed interest payments.
Optimal Structure
Companies aim to establish an optimal capital structure that balances the benefits of debt (tax advantages, leverage) with the risks (financial distress, interest costs). The optimal mix varies by industry, size, and business risk.
Liquidity and Flexibility
Maintaining a flexible capital structure allows a company to adapt to changing economic conditions and opportunities. Excessive debt can limit financial flexibility, while too much equity may lead to underutilization of capital.
Credit Rating
A company’s capital structure affects its credit rating. High debt levels relative to equity can lead to lower credit ratings, impacting borrowing costs and access to capital markets. Maintaining a strong credit rating is crucial for many firms.
Cost of Capital
The mix of debt and equity influences a company’s cost of capital. Debt tends to have a lower cost than equity, but increasing debt beyond a certain point can raise the overall cost of capital due to higher interest rates demanded by investors.
Shareholder Interests
The capital structure decisions impact shareholders directly. High leverage can lead to higher returns on equity when profits exceed the cost of debt, but it also raises financial risk. Equity offerings can dilute existing shareholders’ ownership.
Regulatory Environment
The capital structure choices may be influenced by regulatory constraints and industry-specific regulations. For example, banks and financial institutions often have stringent capital requirements imposed by regulatory bodies.
Risk Management
Effective capital structure management is essential for risk management. Companies must balance the need for growth with the ability to handle financial shocks and economic downturns. An appropriate capital structure can mitigate financial distress risk.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
From a financial standpoint, there are three main documents that can be used to represent an organization:
Balance Sheet: it shows how assets have been acquired by a firm.
Income Statement: it shows the P/L of a company’s (also called bottom line or profit and loss statement).
And Cash Flow Statement: it shows cash inflows and outflows of a firm.
For the sake of this guide, we’ll focus primarily on the balance sheet, as this is the document that shows how the company acquired those and it breaks down liability and equity.
Understanding how assets are built from a financial standpoint
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
A classic balance sheet is comprised of three main accounts:
Assets.
Liability.
Equity.
On the one side, you have the assets or all the things which, from an accounting standpoint, have been deemed as such. On the other end, those assets will be acquired either through liability (debt or other financing forms) or via equity (primarily capital endowments).
For a more in-depth explanation on how balance sheets work:
Optimizing the capital structure
In financial theory, there are several tools to optimize the capital structure of a company. One of those tools is called WACC, and it enables us to compute the “optimal” composition of debt and equity for a firm, considering the market value of the same.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
Indeed, large institutions, firms, and public companies have used in the 1990s leverage as a form of a capital structure optimization, by perhaps taking on more debt. Indeed, with debt comes lower tax rates, and this, in turn, should improve the market valuation of the company, as debt can be pumped in without requiring capital endowments. This has been at the foundation of financial innovation in the 1990s, with private equity firms taking over public companies with leveraged buyouts.
While this might work in theory, in reality, debt is always risky, and it might create a squeeze effect over the company, as a few bad quarters might create liquidity issues. Therefore, while capital structure optimization makes a lot of sense in theory. That is also hard and risky in practice.
Thus, as a small organization, it might make more sense to rather have cash buffers to plan for bad quarters, rather than taking on debt, which might be cheaper in a given period, yet it might silently raise the company’s overall financial risks.
Case Studies
Startup Financing:
Example: A tech startup, XYZ Tech, is founded by a group of entrepreneurs. Initially, they invest their personal savings (equity) into the company. As the company grows, they seek venture capital funding (equity) to accelerate product development and market expansion. By relying on equity financing, XYZ Tech avoids taking on debt in the early stages when cash flow is uncertain.
Real Estate Investment:
Example: A real estate investor, Jane, wants to purchase a rental property worth $500,000. She decides to use a combination of equity and debt. Jane invests $100,000 of her savings (equity) as a down payment and secures a mortgage loan (debt) for the remaining $400,000. She expects rental income (equity) to cover the mortgage payments while building equity through property appreciation.
Publicly Traded Companies:
Example: XYZ Corporation, a publicly traded company, plans to expand its operations globally. To raise capital, XYZ issues corporate bonds (debt) with a face value of $1 billion. Additionally, the company offers new shares (equity) to investors through a secondary stock offering. The proceeds from the bond issuance and equity offering are used to fund the expansion.
Private Equity Buyouts:
Example: A private equity firm, ABC Partners, identifies a well-established retail company, RetailCo, as a potential target for a leveraged buyout (LBO). ABC Partners acquires RetailCo by financing a significant portion of the purchase price with debt. They aim to improve RetailCo’s operations, increase its profitability (equity), and ultimately sell the company at a higher valuation to cover the debt.
Capital Structure in Tech Companies:
Example: Tech giant MegaTech Inc. prefers equity financing for its innovative projects. Instead of taking on debt, MegaTech issues stock options (equity) to its employees, aligning their interests with the company’s long-term success. This approach allows MegaTech to invest heavily in research and development without incurring interest expenses.
Retail Businesses:
Example: A retail chain, SuperMart, plans to open 50 new stores across the country. To finance this expansion, SuperMart secures a loan (debt) from a bank to cover construction and inventory costs. They also use retained earnings (equity) generated from previous profits to contribute to the project’s funding.
Capital Structure during Economic Downturns:
Example: Company ABC, facing economic uncertainties during a recession, decides to prioritize reducing its debt levels. They allocate a portion of their profits (equity) to paying down outstanding loans. While this temporarily reduces shareholder dividends, it enhances the company’s financial stability by lowering interest expenses.
Retail vs. Tech in Capital Structure:
Example: Comparing Amazon (tech) and a traditional retailer, RetailMart, we find that Amazon relies more on equity financing to fund its expansion and innovation initiatives. In contrast, RetailMart, which has been in business for decades, has a higher proportion of debt in its capital structure due to its stable cash flows and creditworthiness.
Risk Assessment in Capital Structure:
Example: Company XYZ assesses its financial risk by analyzing its capital structure. They recognize that their high debt-to-equity ratio increases the risk of financial distress if their revenue declines unexpectedly. To mitigate this risk, they explore options to refinance debt or issue additional equity.
Debt Covenants:
Example: Corporation ABC issues bonds to raise capital. These bonds come with debt covenants, including financial ratios and limits on additional borrowing. If ABC violates these covenants by exceeding the specified debt thresholds, the bondholders have the right to demand immediate repayment, creating financial pressure.
Capital Structure in Mergers and Acquisitions:
Example: Company XYZ plans to acquire Competitor Corp. As part of the acquisition, they assess both companies’ capital structures. XYZ decides to refinance Competitor Corp.’s existing debt with a lower-interest loan (debt restructuring) and also issues new shares (equity) to fund the acquisition.
Industry-Specific Considerations:
Example: Utility Company A operates in the energy sector, characterized by stable cash flows. To finance infrastructure projects, they issue long-term bonds (debt) at favorable interest rates. In contrast, Tech Startup B relies on equity financing to fund research and development for its groundbreaking technology products.
Key takeaways
The capital structure indicates how a firm uses leverage or equity to build its assets and finance its operations.
Capital structuring is used by larger organizations to optimize the mix between debt and equity, as in some cases debt might be less expensive, and a company can finance its growth without diluting its equity and gain a sort of fiscal advantage from that.
At the same time, debt and too much leverage can put substantial short-term risk to the organization. A few bad quarters might create liquidy issues that might also end up in bankruptcy.
That is why for small organizations its important to minimize the amount of debt carried out and enable cash buffers.
Key Highlights
Capital Structure: It represents how an organization finances its operations, using a combination of equity and liabilities (short-term and long-term debt).
Financial Statements: Essential documents used to assess various aspects of a business, including profitability (income statement), asset sourcing (balance sheet), and cash flows (cash flow statement).
Balance Sheet: Shows how assets are acquired by a firm, comprising three main accounts: assets, liabilities, and equity.
Assets: Represent all the things deemed valuable from an accounting standpoint.
Liability: Includes debt and other financing forms used to acquire assets.
Equity: Comprises capital endowments and profit reserves used to acquire assets.
Optimizing the Capital Structure: Financial theory uses tools like WACC to find the “optimal” mix of debt and equity for a firm considering market value.
WACC (Weighted Average Cost of Capital): It assesses the cost of capital by considering the weight of equity and debt.
Capital Structure Optimization: Larger organizations may use leverage to optimize their capital structure, taking on more debt for tax advantages and improved market valuation.
Risks of Debt: While debt can be cheaper, it is also risky and can create liquidity issues for a company, making capital structure optimization challenging and risky in practice.
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country.
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both.
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
