What is Capital Structure For Small Business?

What Small Business Owners Need To Know About Capital

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Capital structure is the composition of long-term liabilities, specific short-term liabilities, like bank notes, common equity, and preferred equity, which make up the funds a business firm uses for its operations and growth. The capital structure of a business firm is essentially the right side of its balance sheet.

Capital structure, broadly, is composed of the firm's debt and equity. There are considerations by management and the stakeholders over what mix of debt and equity to use.

Should more debt financing be used in order to earn a higher return? Should more equity financing be used to avoid the risk of debt and bankruptcy?

For example, the capital structure of XYZ, Inc. is 40% long-term debt (bonds), 10% preferred stock, and 50% common stock.

What is Capital?

Capital for a small business is simply money. It is the financing for a small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes. Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing.

In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock.

Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade information technology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity.

Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.