Capital Structure

Published Jan 25, 2023

Definition of Capital Structure

Capital structure is the mix of debt and equity that a company uses to finance its operations. That means it describes the proportion of a company’s capital that is funded by debt and equity. In most cases, the capital structure of a company is determined by its management and is based on the company’s risk profile, its cost of capital, and its financial goals.

Example

To illustrate this, let’s look at an imaginary company called ABC Inc. ABC Inc. is a small manufacturing company that produces widgets. To finance its operations, ABC Inc. has two sources of capital: debt and equity. The debt consists of a loan from a bank, and the equity consists of the company’s shares. The company’s management decides to finance 70% of its operations with debt and 30% with equity. Or in other words, the company’s capital structure is 70% debt and 30% equity.

Why Capital Structure Matters

Capital structure is an important factor for any company because it affects the company’s risk profile and cost of capital. Companies that rely heavily on debt financing are more exposed to financial risk because they have to make regular payments on their debt. On the other hand, companies that rely heavily on equity financing are more exposed to market risk because their share price may be more volatile.

In addition to that, the cost of capital also depends on the capital structure. Companies with a higher debt-to-equity ratio usually have a higher cost of capital because debt financing is usually more expensive than equity financing. Thus, it is important for companies to find the right balance between debt and equity financing in order to minimize their risk and cost of capital.