Capital Structure Definition, Types, Importance, and Examples

What Is Capital Structure?

Capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.

Equity capital arises from ownership shares in a company and claims to its future cash flows and profits. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure.

Dynamics of Debt and Equity

Both debt and equity can be found on the balance sheet. Company assets, also listed on the balance sheet, are purchased with debt or equity. Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock. A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

When analysts refer to capital structure, they are most likely referring to a firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company's borrowing practices are. Usually, a company that is heavily financed by debt has a more aggressive capital structure and, therefore, poses a greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt is one of the two main ways a company can raise money in the capital markets. Companies benefit from debt because of its tax advantages; interest payments made as a result of borrowing funds may be tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity allows outside investors to take partial ownership of the company. Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back. This is a benefit to the company in the case of declining earnings. On the other hand, equity represents a claim by the owner on the future earnings of the company.

Optimal Capital Structure

Companies that use more debt than equity to finance their assets and fund operating activities have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing total liabilities by total equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's industry peers.

The Bottom Line

Capital structure is the specific mix of debt and equity that a company uses to finance its operations and growth. Debt consists of borrowed money that must be repaid, often with interest, while equity represents ownership stakes in the company. The debt-to-equity (D/E) ratio is a commonly used measure of a company's capital structure and can provide insight into its level of risk. A company with a high proportion of debt in its capital structure may be considered riskier for investors, but may also have greater potential for growth.