An Introduction to Capital Structure
You may hear corporate officers, professional investors, and investment analysts discuss a company's capital structure. This refers to the types of money, and their sources, that are funding a business.
Capital structure can influence the return a company earns for its shareholders, as well as whether or not a firm survives in a recession or depression.
Learn more about the basics of capital structure.
Capital Structure—What It Is and Why It Matters
The term capital structure refers to the percentage of capital (money) at work in a business by type. Broadly speaking, there are two forms of capital: equity capital and debt capital.
Each type of capital has its benefits and drawbacks, and balancing funding sources is important for sustainable business growth. A substantial part of wise corporate stewardship and management is attempting to create a capital structure that produces the ideal balance of risk and reward for shareholders.
Capital structure is important both for Fortune 500 companies and for small business owners trying to determine how much of their start-up money should come from a bank loan without endangering the business.
Investors, shareholders, and analysts will often look at a business's debt-to-equity ratio to determine whether the business is a sound investment. If this ratio is more than 50%, the company is financed by more debt than equity.
Another part of capital structure is working capital, or the available cash a company has on hand. Working capital is the difference between a business's assets and liabilities.
A business with more debt than equity, or more liabilities than assets, is often seen as a riskier investment, though this can vary by industry.
Many businesses are initially funded with the owners' own money, either through savings, investments from family, or leveraging assets such as a retirement plan. But a common source of funding for growing companies is equity.
Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types:
- Contributed capital: Money that was originally invested in the business in exchange for shares of stock or ownership
- Retained earnings: Profits from past years that have been kept by the company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion
Contributed capital can come from shareholder. It may also come from as well as angel investors and venture capitalists.
These are rarer and harder to access, however, financing less than 3% and less than 1% of new businesses respectively. These types of equity funding also require owners to give up a degree of control over their business in return for funding.
Many consider equity capital to be the most expensive type of capital a company can use because its "cost" is the return the firm must earn to attract investment. An unproven startup, for example, may require a much higher return on equity to get investors to purchase the stock than a long-established firm such as Procter & Gamble, which sells everything from toothpaste and shampoo to detergent and beauty products.
The debt capital in a company's capital structure refers to borrowed money that is at work in the business. The cost depends on the health of the company's balance sheet. A triple AAA rated firm can borrow at extremely low rates, while a speculative company with tons of debt may have to pay 15% or more in exchange for debt capital.
There are different varieties of debt capital:
- Loans or credit cards: Many businesses start with loans from family or putting expenses on a credit card. Many also apply for loans from banks or the Small Business Administration. Small banks are often good sources of funding for new businesses.
When applying for a loan from a bank or the Small Business Administration, you will need to show a business plan, financial projections for at least five years, and an expense sheet.
- Long-term bonds: Generally considered the safest type of debt because the company has years, even decades, to come up with the principal while paying interest only in the meantime.
- Short-term commercial paper: Used by giants such as Walmart and General Electric, this amounts to billions of dollars in 24-hour loans from the capital markets. They can help businesses meet day-to-day working capital requirements such as payroll and utility bills.
- Vendor financing: In this instance, a company can sell goods before they have to pay the bill to the vendor. This can drastically increase the return on equity but costs the company nothing. One secret to Sam Walton's success at Walmart was selling Tide detergent before having to pay the bill to Procter & Gamble, in effect, using P&G's money to grow his retail enterprise.
- Policyholder "float": Used by insurance companies, this is money that doesn't belong to the firm but that can be used or earn interest until it has to pay it out.
Seeking the Optimal Capital Structure
Many middle-class investors believe the goal of life is to be debt-free. When it comes to a business's capital structure, however, that idea is less straightforward.
Many of the most successful companies in the world base their capital structure on one simple consideration—the cost of capital.
If you can borrow money at 7% for 30 years in a world of 3% inflation and reinvest it in core operations at a 15% return, you would be wise to consider at least 40% to 50% in debt capital in your overall capital structure—particularly if your sales and cost structure are relatively stable.
If you sell an essential product, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a booming market. This is where managerial talent, experience, and wisdom come into play.
To truly understand the idea of capital structure, the DuPont model provides insight into how capital structure represents one of the three components that determine the rate of return a company will earn for its owners and investors.
The best managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher-return products, leveraging debt wisely, and more.