What is capital structure?

What is capital structure? It’s a basic way of determining how a company stays afloat, healthy, and profitable. 

Any board member or corporate leader with adequate corporate governance training should be familiar with the term and what the metric looks like for their company, as it can vary.

Capital structure is the combination of a company’s own wealth and borrowed wealth used to finance its operations. 

The above is as simple as the concept can be defined, but capital structure can quickly get complex, as the balance between owned and borrowed wealth takes several forms and looks different for each company.

Usually, it’s the following:

• Share capital (funds raised through the sale of shares to individuals or corporations in exchange for a say in the running of the company). 
• Cash reserves.
• Any cash surpluses and retained earnings generated by current business activity.

• Loans. This is, by far, the most common form of borrowed wealth and a core source of finance for many companies. It often includes some kind of tax break benefit and lets business owners retain corporate control, where raising money through shares gives away a portion of control for each share sold. 
• Debentures (Unsecured debt instruments or bonds – essentially a long-term kind of borrowing). 
• Public deposits.

It’s important because it provides a crucial window into how a company finances its daily operations. Corporate stakeholders can tell a lot about a company’s financial management by looking through this one lens. 

Yes, but it’s not a single, ideal percentage split. Nothing in governance is ever that simple. 

The commonly cited “ideal” capital structure is known as the “optimal capital structure” – the best mix of owned and borrowed wealth that maximises the company’s market value. 

Naturally, this will differ for every company.

Usually, you would use a metric called the “weighted average cost of capital (WACC)”. This is basically the average post-tax cost of finding money to finance a business.

Yes, as long as the company’s leaders and financial managers have done their homework and have verified that the business can survive using the chosen model.

Companies with higher debt and lower levels of owned money have an aggressive capital structure. In the right environment, this can lead to higher growth rates but also carries higher risk. 

Companies with higher levels of owned money relative to debt have a conservative capital structure. These companies often avoid excessive risk associated with borrowing, but their growth rate may suffer because of it.

1. It shows how your company pays for itself and finances efforts to generate profit.
2. Determining capital structure is crucial in order to be clear on things like risk, market conditions, and corporate strategy. 
3. It can be a challenge to arrive at the optimal capital structure because you need to navigate the demands and opinions of many stakeholders while deciding what’s best for the business.