Loading the player...

What is a 'Capital Structure'

The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

BREAKING DOWN 'Capital Structure'

A firm's capital structure can be a mixture of long-term debt, short-term debt, common equity and preferred equity. A company's proportion of short- and long-term debt is considered when analyzing 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 is. Usually, a company that is heavily financed by debt has a more aggressive capital structure and therefore poses greater risk to investors. This risk, however, may be the primary source of the firm's growth.

Debt vs. Equity

Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to issue debt because of the tax advantages. Interest payments are 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 is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner.

Debt-to-Equity Ratio as a Measure of Capital Structure

Both debt and equity can be found on the balance sheet. The assets listed on the balance sheet are purchased with this debt and equity. Companies that use more debt than equity to finance assets 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/or an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. It is the goal of company management to find the optimal mix of debt and equity, also referred to as the optimal capital structure.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by 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 peers.

RELATED TERMS
  1. Capitalization Structure

    Capitalization structure refers to the proportion of debt and ...
  2. Corporate Capital

    Corporate capital refers to the assets a business has available ...
  3. Long-Term Debt To Capitalization ...

    A ratio showing the financial leverage of a firm, calculated ...
  4. Debt Financing

    Debt financing occurs when a firm raises money for working capital ...
  5. Optimal Capital Structure

    The best debt-to-equity ratio for a firm that maximizes its value. ...
  6. Capitalization Ratios

    Capitalization ratios are indicators that measure the proportion ...
Related Articles
  1. Investing

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  2. Investing

    Lowe's Stock: Capital Structure Analysis (LOW)

    Examine Lowe's Companies' equity capitalization, debt capitalization and enterprise value to analyze trends in the retailer's capital structure.
  3. Investing

    Disney Stock: Capital Structure Analysis (DIS)

    Learn about Disney's capital structure and why the company can afford to be more aggressive with its current level of debt exposure.
  4. Investing

    Microsoft Stock: Capital Structure Analysis (MSFT)

    Analyze Microsoft's capital structure to determine the roles of debt and equity in its financing, and explore what these trends say about the cost of capital.
  5. Investing

    Understanding Apple's Capital Structure

    The technology behemoth has completely revamped its capital structure, taking advantage of ZIRP and issuing billions of dollars worth of cheap debt.
  6. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  7. Investing

    IBM Stock: Capital Structure Analysis

    Learn about IBM's capital structure and why its market debt-to-equity ratio is lower than the rest of the industry, even though its market capitalization declined.
  8. Investing

    AT&T Stock: Capital Structure Analysis (T)

    Analyze AT&T's capital structure to discover important trends in the company's financing. Find out how and why debt and equity have changed in recent years.
  9. Investing

    Alibaba Stock: Capital Structure Analysis (BABA)

    Review Alibaba's capital structure to determine the contribution of debt and equity financing. Identify trends and important drivers of capital structure.
RELATED FAQS
  1. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
  2. How does a company choose between debt and equity in its capital structure?

    Learn about the benefits and drawbacks of debt and equity financing. Find out how to compare capital structures using cost ... Read Answer >>
  3. How does a company's capitalization structure affect its profitability?

    Learn about capitalization structure and how the combination of debt and equity a company uses to fund operations can affect ... Read Answer >>
  4. What are some strategies companies commonly use to reduce their debt to capital ratio?

    Explore the different strategies that companies can employ and steps that can be taken to reduce a company's debt to capital ... Read Answer >>
  5. What is the difference between cost of debt capital and cost of equity?

    Learn about how the costs of debt and equity capital differ and how to calculate each using interest and tax rates and stock ... Read Answer >>
Hot Definitions
  1. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. ...
  2. Receivables Turnover Ratio

    Receivables turnover ratio is an accounting measure used to quantify a firm's effectiveness in extending credit and in collecting ...
  3. Treasury Yield

    Treasury yield is the return on investment, expressed as a percentage, on the U.S. government's debt obligations.
  4. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  5. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  6. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
Trading Center