If you're considering investing in a company, there are many ways to determine its health. One metric to look at is its capital structure.
What Is Capital Structure and its Importance?
A company's capital structure refers to how it finances its operations and growth with different sources of funds, such as bond issues, long-term notes payable, common stock, preferred stock, or retained earnings.
Capital structure is sometimes referred to as "financial leverage," as each business has to consider the optimal ratio for running its business between debt and equity. Corporate executives have to keep capital structure in mind to try to either maximize shareholders' wealth, or increase the company's value.
Also, financial institutions such as banks or other lenders have to consider their risk in helping a company finance its operations. If the company appears to be highly leveraged -- with substantially more debt than equity -- it is a greater risk, as the company owes more than it earns, while a low-leveraged company appears to be less of a risk, as it earns more than it owes.
What Are the Types of Capital Structure?
As you might suspect, there are two main forms or sources of capital for a capital structure: equity capital and debt capital.
This is defined as the money put up by the shareholders -- owners of the company. Equity capital itself usually consists of two sources. One is contributed capital, or the money invested in the business by the purchase of shares of stock. The other is ownership and retained earnings, or the profits from previous years kept by the company and used to strengthen its balance sheet or to fund growth, expansion and acquisitions.
Equity capital, however, is seen by many as the most expensive means to use, because of the cost, or the size of return the company must earn to attract investors.
Debt capital in a company's capital structure refers to borrowed money at work in the business. Debt is considered the cheaper of the two forms of financing capital, because the interest payments on the debt are a tax deductible expense.
Long-term bonds are generally considered the safest kind of debt capital, because the company has years or even decades to come up with the principal while paying only interest until the bond's maturity. Other sources of debt capital can include short-term commercial paper.
The cost of debt capital in the capital structure will depend on the company's balance sheet at the time it issues bonds to lenders. A Triple AAA rated firm can borrow at extremely low rates compared with one with massive amounts of existing debt, which may have to pay 15% or more in exchange for debt capital.
It might seem that the ideal capital structure is where a company is able to finance all its operations and needs with equity, just as a family with enough income can live debt-free. But that means ignoring a factor many of the most successful companies have to also consider in determining their capital structure: the cost of capital.
If you sell a product people need, the debt will be a lower risk than if you rely on a cyclical or boom business and dependent on the boom to continue to fund your operations.
Great managers are able to consistently reduce their weighted average cost of capital by increasing productivity, or seeking out products with a higher return, as examples. This is why highly profitable consumer staples businesses take advantage of long-term debt by issuing corporate bonds.
Optimal capital structure implies that at a particular ratio between debt and equity, the cost of capital is minimal and the value of the firm is maximized.
That way, when a company decides to raise money, it can choose between debt and equity. Using mostly equity to fund the purchase of assets is considered using lower leverage; while using mostly debt is considered higher leverage.
Another, less-well-known form of capital besides equity and debt capital, is called vendor financing. Vendor financing occurs when a company can sell goods before having to pay their vendor. This can dramatically increase the company's return on equity, but without costing the company anything up front.
Policy Holder Float Financing
With an auto insurer, for instance, the policy holder "float" represents money not belonging to the firm that it can use and to earn on an investment until it has to pay it out for accidents or medical bills.
What Is an Example of Capital Structure?
Let's consider two different examples of capital structure:
Company A, for our purposes, has $150,000 in assets and $50,000 in liabilities. This means Company A's equity is $100,000.
The company's capital structure is therefore such that for every 50 cents of debt, the company makes $1 of equity.
This, then, would be an example of a low-leverage, or even low-risk, equity capital-structured company.
Now, take its cross-town rival, Company B. Company B has $120,000 in assets, $100,000 in debt and therefore $20,000 in equity.
Company B is "highly leveraged." For every $5 of debt, the company has $1 in equity. This means not only the company needs to increase its returns to be able to finance its debt, eventually, but the company also will be viewed as a greater risk to future lenders.
A real-life example of a vendor financing capital structure was when Sam Walton's Wal-Mart (now Walmart (WMT - Get Report) ) took off. Walton was able to often sell Tide and other Procter & Gamble products before having to pay P&G (PG - Get Report) , effectively using P&G's money to grow.
How Do You Calculate Capital Structure?
Since capital structure is the amount of debt or equity or both employed by a firm to fund its operations and finance its assets, capital structure is typically expressed as a debt-to-equity ratio.
To calculate the debt-to-equity ratio, the formula is relatively straight forward.
The company's total liabilities are divided by its total shareholder's equity.
Using our previous examples, Company A has $150,000 in assets, and $50,000 in liabilities.
Company A's equity is determined by subtracting its liabilities from its overall assets, meaning it has $100,000 in equity.
Dividing Company A's total liabilities of $50,000 by its total shareholders' equity of $100,000, it has a Debt/Equity ratio of 0.5, meaning for every 50 cents of debt, the company has $1 of equity -- and is therefore low-leveraged.
Company B on the other hand, has $120,000 in assets, but $100,000 in debt. That means its equity is $20,000, but its liabilities are $100,000.
Debt/Equity Ratio = $100,000 divided by $20,000 = 5.
This means that for every $5 in debt, Company B hold $1 in equity.
That's why Company B is considered "highly leveraged."