What is Capital Structure?

Capital Structure is a company's or an organizations financial structure is its way of financing its operational costs or expansion. Most companies will resort to loans or shares. In this case, capital refers to the amount of money available to a company; this includes all monies contributed by owners/shareholders and that obtained from loans.

How does a Capital Structure Work?

The capital structure represents a mixture of short-term debt, long-term debt, preferred equity, and common equity. The proportion of a long- and short-term debt is put into consideration during the process of capital structure analysis. So, when you hear analysts talking about capital structure, what they are simply referring to is the debt-to-equity ratio that provides insight into the company's possible risks. Companies with heavy debt financing imply that their capital structure is aggressive, and its investors are at a greater risk of losing their investment. It may also be a stepping stone to the company's growth. On the other hand, companies that use equity more than debt to settle payments for their assets have a low leverage ratio and a conservative capital structure. When firms have to make tradeoffs, they usually decide whether to raise equity or debt. In this case, it is the duty of managers to ensure that they balance the two to get a capital structure that is optimal. Generally, companies use equity and debt to fund different business activities such as:

• Business operations
• Capital expenditures
• Acquisitions, including other investments

Debt Capital vs. Equity Capital

When firms have to make tradeoffs, they usually decide whether to raise equity or debt. In this case, it is the duty of managers to ensure that they balance the two to get a capital structure that is optimal. Generally, companies use equity and debt to fund different business activities such as:

• Business operations
• Capital expenditures
• Acquisitions, including other investments

What optimizing basically means is to achieve a debt-to-equity ratio that is in line with the average of the industry. It can also mean achieving a lower debt-to-equity ratio. For a company to be able to calculate its capitalization structure, it needs to know its equity and debts market value. Companies like issuing debt for various reasons:

• It provides companies with a tax advantage. The payment of the interest is tax-deductible.
• Unlike equity, debt allows the business or company to retain ownership
• Also, when companies are experiencing low-interest rates, it is easy for them to access debt.

Equity capital, on the other hand, is more expensive when you compare it to debt capital, especially when a company is experiencing low-interest rates in the market. However, what makes equity capital favorable is that unlike debt capital, companies are not obliged to pay back in case earnings happen to decline.