The capitalization structure of a business is its foundation. From its first sale to the projectsit invests in down the road, everything begins with the way it finances its operations. The capitalization structure can have a huge impact on a company's profitability. Companies are financed either through equity or debt and the levels make a difference to their financial health and financial management.
Key Takeaways
- Capital structure refers to how a company's operations are funded; either by equity or debt.
- Equity financing involves capital invested in the business through outside investors, usually shareholders when a company goes public.
- Debt financing involves the borrowing of money, usually through bank loans, but can also include other debt, such as credit card debt.
- Both equity and debt come with costs: The cost of equity is represented by the rate of return on investment that shareholders expect and for debt, it is the interest rate charged by the lender.
- A healthy mix of equity and debt is ideal for a company.
What Is a Capitalization Structure?
Capitalization structure (more commonly called capital structure) refers to the money a company uses to fund operations and where that money comes from. Capital can be raised either through the acquisition of debt or through equity
Equity financing comes from the sale of stock to shareholders. Debt can come from many sources, such as bank loans, personal loans, and credit card debt, but it must always be repaid at a later date, usually with interest.
Cost of Capital
Both types of capital financing carry some degree of expense that must be paid to access funds, called the cost of capital. For debt capital, this is the interest rate charged by the lender.
The cost of equity is represented by the rate of return on investment that shareholders expect, which generally consists of capital gains (price appreciation) and/or dividends. While debt tends to cost less than equity, both types of capital financing impact a company's profit margins in important ways.
Debt Capital
Perhaps the clearest example of this is the impact of debt on the bottom line. Somewhere between operational expenses and the net profit figure on a company's income statement lies expenses incurred for the payment of debts. A company with a particularly debt-heavy capital structure makes larger interest payments each year, thereby reducing net profit.
Debt capital can also have a positive effect on profitability. Debt allows companies to leverage existing funds, thereby enabling more rapid expansion than would otherwise be possible. The effective use of debt financing results in an increase in revenue that exceeds the expense of interest payments. In addition, interest payments are tax-deductible, reducing a company's overall tax burden.
Equity Capital
The impact of equity financing on a company's profit margins is equally important, though not quite so straightforward. While equity funds stimulate growth without requiring repayment, shareholders are granted limited ownership rights, including voting rights.
They also expect a return on their investment which may include dividends, which are usually only paid if the company turns a profit consistently. A business funded by shareholder equity is beholden to its investors and must remain consistently profitable in order to fulfill this obligation.
If a company is already financed with equity, further equity financing will dilute the ownership stakes of the current investors.
Capital Structure and Profitability
Business ownership is shared, so the proverbial pie of profits must be divided into a greater number of pieces. A company funded fully by debt may have hefty interest payments each month, but when all is said and done, the profits belong entirely to the business owners.
Without shareholder dividends to pay, the profits can be reinvested in the business through the purchase of new equipment or by opening a new location, generating even greater profits down the road.
Another indirect effect of capital structure on profitability is its impact on the potential availability of additional capital if it is needed in the future. A company with a particularly high debt-to-equity ratio may be seen as unnecessarily risky by both lenders and potential shareholders, making it difficult to raise additional funds. Limited access to capital funding, in turn, limits the business's growth potential, keeping profit margins stagnant.
What Are the 2 Main Parts of Capital Structure?
The two main parts of capital structure are debt and equity. Equity includes the capital that a business owner has put in as well as any money from outside investors. For public companies, this includes the money shareholders have put in through the purchase of stocks. Debt includes any borrowed money by a company, including loans and credit cards. Equity does not need to be paid back, but a portion of ownership is lost. Debt does have to be paid back, but there is no ownership lost.
What Is a Good Capital Structure?
A good capital structure is one that consists of a good mix of both equity and debt, with the goal of having the lowest weighted average cost of capital (WACC). A company shouldn't have so much debt that it struggles to make payments or that debt payments significantly eat up a portion of income. Similarly, a company shouldn't rely too much on equity financing as it requires giving up some control of the company
What Is an Example of Capital Structure?
An example of capital structure would be a new company that has been operating for two years and needs to raise money to open up more stores. It takes on private investors that contribute money to the company. In return, these new investors get 25% ownership of the company and can now make decisions regarding the company. After five years, the company again needs money to expand. This time, it takes out a loan with a bank, where it makes monthly payments back to the bank of principal and interest. The company's capital structure consists of equity from the private investors and debt from the bank.
The Bottom Line
Companies can finance operations either through equity or debt. Both options have their pros and cons and which is right will depend on the company and its goals. Most companies typically use a mix of both equity and debt financing, which allows companies to maintain a certain amount of control without heavy debt burdens.
