An Introduction to Capital Structure

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You may hear corporate officers, professional investors, and investment analysts discuss a company's capital structure. The concept is extremely important because it can influence the return a company earns for its shareholders and whether or not a firm survives in a recession or depression.

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 a substantial part of wise corporate stewardship and management is attempting to find the perfect capital structure regarding risk/reward payoff for shareholders. This is true for Fortune 500 companies as well as small business owners trying to determine how much of their start-up money should come from a bank loan without endangering the business.

Let's take a moment to look at these two forms of capital a bit more closely.

Equity Capital 

Equity capital refers to money put up and owned by the shareholders (owners). Typically, equity capital consists of two types: 

  • Contributed capital: The 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

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. A speculative mining company that is looking for silver in a remote region of Africa 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.

Debt Capital

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 vs. a speculative company with tons of debt, which may have to pay 15% or more in exchange for debt capital. There are different varieties of debt capital:

  • Long-term bonds: Generally considered the safest type 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 to 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 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": In the case of insurance companies, this is money that doesn't belong to the firm but that it gets to use and earn an investment on until it has to pay it out for auto accidents or medical bills. The cost of other forms of capital in the capital structure varies greatly on a case-by-case basis and often comes down to the talent and discipline of managers.

Seeking the Optimal Capital Structure

Many middle-class investors believe the goal in life is to be debt-free. When you reach the upper echelons of finance, 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 people must have, the debt will be a much lower risk than if you operate a theme park in a tourist town at the height of a boom market. Again, this is where managerial talent, experience, and wisdom come into play.

The great managers have a knack for consistently lowering their weighted average cost of capital by increasing productivity, seeking out higher-return products, and more. This is the reason you often see highly profitable consumer staples manufacturers take advantage of long-term debt by issuing corporate bonds.

To truly understand the idea of capital structure,  the DuPont model provides insight into how capital structure represents one of the three components in determining the rate of return a company will earn on the money its owners have invested in it. Whether you own a donut shop or are considering investing in publicly-traded stocks, it's knowledge you simply must have if you want to develop a better understanding of the risks and rewards facing your money.