Capital Structure

DEFINITION of 'Capital Structure'

A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity. 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.

Read more: Capital Structure Definition |

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Financial Strucutre, Capital Structure (Capitalization), and Leverage Explained

Definitions, Meaning, and Example Calculations
Business Encyclopedia, ISBN 978-1-929500-10-9. Updated 2015-11-20.

Company capital and financial structures are built from balance sheet liabilities and equities. These structures are the mechanisms
by which owners and creditors share risks and rewards in proportion to their share of company funding.

What are financial and capital structures?

The term structure is used in business in several different
ways. The terms "governance,""business," and "legal," are all associated with their own "structures" for
instance, referring to aspects of company set up and operation.
Two other similar terms are frequently used to describe the nature of the company's financial position: Financial
structure and capital structure. These structures concern the "Liabilities + Equities" side of balance sheet
equation:
Assets = Liabilties + Equities

This article defines, explains, and illustrates these terms with examples.

Financial structure refers to the balance between all of the company's liabilities and its equities. It
thus concerns the entire "Liabilities+Equities" side of the balance sheet.

Capital structure, by contrast, includes equities and only the long term liabilities. It refers to the
makeup of the company's underlying value, in particular the relative balance between funding from equities
and funding from long term debt. The presumption is that funds from both sources are used for acquiring
income-producing assets. Capital structure is also known as capitalization.

For comparing company debt to equities, financial structure is therefore more sensitive than capital structure to
factors reflected in short term liabilities, such as working capital and cash flow, salaries payable, accounts
payable, and taxes payable.
This article further defines and illustrates financial and capital structures in the context of related terms. A
similar concept, asset structure, is discussed in its own encyclopedia entry.
Financial and capital structures can be derived from the company's balance sheet:

Example balance sheet. The components of asset structure, financial structure, and capital structure (Capitalization) all appear on
the company's balance sheet. These are evaluated in terms of the relative magnitudes of different components within each category.

The relative magnitudes of components in each of these structures show how risks and rewards of company
performance are shared between investor owners on the one hand, and lenders and other creditors on the
other. For more on these structures and the sharing of risks and rewards, see the section below The meaning
of leverage for investors and lenders.

Contents

What are financial and capital structure?

How is financial structure defined and explained? Illustrated example.

How is financial leverage defined and measured?

How is capital structure (capitalization) defined and explained? Illustrated example.

How is capital leverage defined and measured?

What is the role of leverage in business risk, financial risk, and gearing ratios?

When Is there too much debt? Too little debt?

Too much debt.

Too little debt.

Acceptable leverage metrics and target leverage metrics.

How do companies change financial and capital structures?

What are the consequences of leverage for investors? How do creditors and owners share risks and
rewards?

How is financial structure defined and explained? Illustrated example.

Financial structure describes the sourcing of all funds a company uses for acquiring
assets and paying expenses.
There are only two kinds of sources for such funds, (1) equities and (2) debt funding, and the company's
financial structure describes the fraction of total funding that comes from each source. These two sources
taken together are one complete side of the balance sheet:

Equities: What the company owns outright, reported on the balance sheet under "Equities" (or
"Stockholders Equities"). Equities, in turn, come from two sources:
Paid in capital, which payments received for stock shares purchased directly from the company when the
shares are issued.
Retained earnings, which are after tax profits (earnings) retained by the company after dividends have
been paid to shareholders.

Debt financing: Funds acquired through debt financing come primarily from bank loans and the sale
of bonds. Note that the company's debt (balance sheet liabilities) also includes short term obligations such
as short term notes payable, accounts payable, salaries payable, and taxes payable.

Those interested in a company's financial structure are primarily concerned with comparing the percentages of
total funding from each source.
How is financial leverage defined and measured?
One measure of the balance between funding sources is a leverage metric, the Total debt to equities ratio.
This metric is sometimes called simply the Debt to equities ratio, or even more simply the Debt ratio. Some
textbooks symbolize this ratio as B / V, where B is the company's total debt and V is company "value" or total
equities. (A similar but different leverage metric, the "Long term debt to equities ratio" is considered in the
following section.)

The total debt to equities ratio is calculated from entries on the company's balance sheet. The figures for this
example appear in the "Financial Structure" region of the example balance sheet above:
At the end of the reporting period, Grande Corporation's liabilities totaled $8,938,000 and Stockholder equities
totaled $13,137,000. Therefore, ...
Total debt to equities ratio (B / V):
B/V

= Total liabilities / Total stockholders equities

= $8,938,000 / $13,137,000
= 0.68

The greater the debt funding component (the higher the total debt to equities ratio), the higher the degree
of leverage in the company's financial structure. For the implications of different leverage values, see the
section below Leverage Consequences for Investors.

How is capital structure (capitalization) defined and explained? Illustrated example.

Capital structure describes the sources of funds a company uses for acquiring income-producing assets. The
focus on these funds contrasts with the financial structure concept (described above) which includes all of the
company's debt and equities. As Exhibit 1 above shows, the capital contents lie completely within the financial
contents. The capital version, that is, covers a subset of the financial version.
Those interested in a company's capital structure are primarily concerned with comparing the percentages of
total funding for income-producing assets that come from each sourcethat is, they are primarily concerned
with knowing whether capital funding is primarily equity funding or debt funding.
How is capital leverage defined and measured?
One measure of the balance between capital funding sources is another leverage metric, the Long term debt to
equities ratio. (Similar to the other leverage metric discussed above for financial structure, the Total debt to
equities ratio). Like the other metric, the long term debt to equities ratio is calculated from entries on the
company's balance sheet. The figures for this example appear in the "Capital Structure" region of the example
balance sheet above:
At the end of the reporting period, Grande Corporation's long term liabilities totaled $5,474,000 and
Stockholder equities totaled $13,137,000.
Long term debt to equities ratio:
= Total long term liabilities / Total stockholders equities
= $5,474,000 / $13,137,000
= 0.42
The greater the debt funding component (the higher the long term debt to equities ratio), the higher the degree
of leverage in the company's capital structure. For more on the implications of different leverage values see the
sections below discussed below as Leverage and Gearing Ratiosand Leverage Consequences for Investors.

What is the role of leverage in business risk, financial risk, and gearing ratios?
A high degree of leverage has several implications. A highly leveraged company...

Provides greater profitability and a higher return on investment (or return on equity) to its share holding
owners, than a company with less leverageif and only if business performance is good (as in a good
economy).

When business is poor, a highly leveraged company provides lower profits and lower return on return
on equity to its share holding owners, than a company with less leverage when business is poor (as in a
poor economy).

The higher the degree of leverage (i.e., the more the company's financing depends on debt), the higher the
potential rewards and also the higher the potential loss for owners. This consequence of high leverage is called
a high business risk: business risk is usually measured as the potential variability of the company's before tax
earnings from its assets. The potential range of pre tax earnings is usually given as a range of possible results
for earnings before interest and taxes (EBIT).
Analysts also refer to a second risk factor that accompanies high levels of leverage, financial risk. From its
earnings before interest and taxes, a company must first pay interest due on loans, bonds, and other debt
service, before paying dividends to stock holders and/or claiming retained earnings. A company with high
leverage simply has more debt and therefore more debt service obligations to pay periodically than a company
with lower leverage. When EBIT, is very low, the highly leveraged company faces the financial risk that it may
not be able to meet it's financial obligations. When a company has high financial risk, its credit ratings
and bond ratings
For analysis of leverage, business risk, and financial risk, the term gearing ratio is commonly used for several
leverage metrics. The term "gearing" is inspired by mechanical gearing, where a smaller diameter gear wheel
gains leverage (power) by turning a larger wheel. In business, owners and their relatively smaller equity gain
leverage to bring in larger earnings by using relatively more debt financing (higher gearing). In any case, the
term gearing ratio may refer to:

Total debt to equity ratio (or B/V, described above under Financial Structure) where B = total debt
and V = "Value," or Total Equity

Total debt to total assets (total debt / total assets). Presented in textbooks as B/TA, where B = total
debt and TA = total assets.

Total stockholders equities times interest earned (EBIT / total interest)

Equity ratio (equity / assets)

Examples in the next section show how high leverage can bring high owner returns (high earnings per share,
high return on equity) if sales revenues are strong. They also show how profits and owner returns suffer in a
highly leveraged company when sales are weak.

What are the consequences of leverage for investors? How do owners and creditors share risks
and rewards.
The implications of financial structure leverage for investment measures are probably best demonstrated with a
numerical example such as the following. This section illustrates the potential impact of leverage and sales

performance on investor gains and losses. The next section shows how the risks associated with different sales
and leverage figures can be measured.
This example considers four levels of sales performance, and the resulting investor gains or losses four
degrees of leverage. Consider first the before-tax earnings (Earnings before interest and taxes, EBIT) that a
company expects under each of four possible levels of sales revenues:
Management believes there is a very small but real probability that sales next year will be 0. This could happen
in the event of a crippling labor strike, or a natural disaster (earthquake at company site), or the loss of several
major law suits pending against the company. The first column (0 Sales) shows how 0 sales would result in an
EBIT of -$5,000. Three other levels of sales revenue levels are also anticipated:

Low sales: $15,000,000 revenues resulting in $4,000,000 EBIT

Medium sales: $30,000,000 revenues resulting in $13,000,000 EBIT

High sales: $45,000,000 revenues resulting in $25,000,000 EBIT

What will be the impact of sales revenues on investor earnings per share and return on equity? The answer is:
that depends on the financial structure of the company, especially the degree of leverage.
The table below shows four possible financial structures, including
"0 Leverage," and "Low," "Medium," and "High" leverage structures.
Notice especially that:

All four structures have exactly the same asset total asset book value ($22,075,000). In other words,
all fourstructures are associated with the same "left side" of the balance sheet.

What differs between structures is the right hand side of the balance sheet: Shareholder Equity +
Liabilities must, of course equal the asset's $22,075,000, but the four levels of leverage distribute that total
differently between equities and debt (liabilities).

Leverage resulting from these structures is given in the bottom two rows of the table, in green cells.
Total debt to equity (B/V) ranges from 0.0 to 3.00, while the debt to assets ratio ranges from 0.0 to 0.75.

Each structure has the same equity value per share of stock outstanding ($110). However, as the size
of the equity component decreases (going from 0 leverage to high leverage), the number of shares
outstanding also decreases.

The bottom two rows (in green) hold two of the gearing ratios, or leverage metrics described above:
Total debt to Equity (B/V) and Total Debt to Total assets (B/TA). These are calculated directly from the
figures above them for Total assets (TA), Total debt (B), and Total equity (V). Leverage starts at 0 in the
left most column and rises moving right in the table.

The table below applies the four levels of sales revenues to each of the four degrees of leverage:

Each of the four panels in this table shows how EBIT turns into net earnings after taxes, earnings per share
(EPS), and shareholder return on equity (ROE). Comparing these metrics across leverage and sales revenues
carries several unmistakeable messages, which are easier read from the graphical images.

Operating leverage graphed from the table above."

The four graphs above are plotted from results in the four-panel table above. All four graphs show:

The impact of leverage on investor gains is about the same, regardless of which leverage metric is
used (B/V or B/TA) and regardless of which metric measures investor gains (EPS or ROE).

The four lines in each graph each represent a different level of sales revenues, ranging from 0 sales at
bottom, to high sales at top.

In all four graphs, the plotted lines are bunched relatively close together at left (0 leverage) and then
fan out moving right (towards higher leverage). This clearly shows that investors have much more to gain
as much more to lose under high leverage. Considering just the top graph, Earnings per share vs Debt to
Equity (EPS vs. B/V):
At 0 leverage, the range of possible EPS returns is small. At 0 leverage, EPS ranges from negative to
positive, from $16.25 (with 0 sales) to $81.25, a range of $97.50.
The range of possible EPS returns is about three times larger under high leverage. Under high leverage,
EPS ranges from negative to positive, from $91.49 to $298.51, a range of $390.00.

When is There Too Much Debt? Too Little Debt?

Several groups have a keen interest in evaluating financial and capital structure:

Lenders considering making loans to the company

Investors considering buying the company's financial securities

Company senior management, considering the acquisition and use of funds

All of these parties will want to judge whether the company is carrying "too much" or "too little" debt.
Too Much Debt
A company is carrying too much debt when debt service costs are burdensome, that is, when

The company cannot readily pay the interest due on its bonds and bank loans.

When debt service costs reduce net income to an unacceptable level.

When there is a high risk the company will default on its loans and/or bonds. In a highly leveraged
company, the risk of these unpleasant outcomes rises if profits and profitability decrease or if the general
economy enters a period of low growth.

In brief, High levels of leverage are dangerous in a poor economy or any other time when a company's earning
prospects are poor.
Too Little Debt
A company may be viewed as carrying too little debt when all of these three conditions exist:
1.

There is a credible opportunity to grow revenues and profits by increasing investments in incomeproducing assets or activities such as research and development, marketing, infrastructure
renewal/modernization, or reorganization.

2.

Earnings and equity funding are not providing sufficient funds to pursue these opportunities.

3.

The company should be able to pay additional debt-service expenses, without lowering profits
unacceptably.

In brief, increasing leverage may be advisable when the company can readily afford additional debt service
costs, and when additional borrowed funds enable investments that promise a good return. "Good returns" are
returns that outweigh the costs of borrowing.
Acceptable Leverage Metrics and Target Leverage Metrics
In deciding whether the company's capital structure is or is not too highly leveraged, investors will consider
several factors:

The company's reported earnings before interest and Taxes (EBIT) compared to:
Industry standard EBIT. Comparing company EBIt to EBIT for other companies in the same industry
indicates whether or not the company's earning power in its own industry is strong.
The company's Net earnings (earnings after taxes and interest have been paid). A comparison of EBIT to
Net earnings for the same period is one indicator of whether or not financing costs (interest) are reducing
profits to an unacceptable level.

The company's debt/equity ratios compared to Industry standard debt ratios.

Acceptable and typical debt/equity ratios vary considerably between industries. Companies in capital
intensive industries such as automobile manufacturing, for instance, typically finance most of their capital
assets through debt, resulting in long term debt to equity ratios grater than 1.0 .
Companies in the technology sector, by contrast, typically have ratios on the order of 0.20 - 0.40. In brief,
analysts will compare any given company's ratios to industry standards.

Trends or recent changes in the company's financial structure and capital structure. They will want to
know whether the reasons for significant changes were temporary (or one-time) situations or continuing
situations.

Individual sources of the company's debt as well as total debt. This understanding helps explain the
actual cost of debt service, risk of default, and the company's prospects for re-negotiating debt if
necessary.

The company's likely earnings performance for the foreseeable future. Projected earnings
performance should be adequate to pay debt service and still provide acceptable retained earnings and/or
shareholder dividends.

Capital structure, moreover, shows how risks and gains are divided between investor owners and investor
creditors:

If a highly leveraged company fails and enters bankruptcy, creditors will probably take the larger loss:
loans to the company may have to be written off and bondholders may find their securities worthless.

On the other hand if a company with very low debt-to-equity ratios fails, creditors will likely be paid off.
When a bankrupt company is liquidated, creditors have preference over shareholders in receiving
liquidation funds, and a low debt-to-equity ratio means there will probably be funding sufficient to cover
outstanding obligations

How do companies change financial and capital structures?

For most companies, financial structure and capital structure change by a small amount more or less
continuously. This is because the reported values of several structural components may be especially fluid from
period to period: short term liabilities, long term liabilities, and even retained earnings, for instance.
For the short term, a company can deliberately increase leverage by taking out loans or issuing bonds. It can
abruptly decrease leverage and increase equity by issuing and selling new shares of stock. Absent these
actions, a profitable profit-making company will gradually reduce leverage as long term loans and bonds are
paid off, and as retained earnings from profits grow.
By Marty Schmidt. Copyright 2004-2015. Solution Matrix Limited. Find us on