What Is Capital Structure And Why It Matters In Business

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).

Understanding financial statements

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.

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.

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