Understanding Capital Structure: Key Terms and Concepts to Get Started

Tom Siska

Last Modified : Sep 18, 2024

Reviewed by: Bruce Sayer

Understanding capital structure is essential for analyzing how a company finances its operations, growth, and acquisitions. Capital structure refers to the mix of debt, equity, and other financing sources a company uses to fund its activities. Here are some key terms and concepts to help you understand capital structure:

1. Equity

• Common Stock: Represents ownership in the company. Common shareholders have voting rights and are entitled to dividends, but they are last in line to receive any payout in the event of liquidation.
• Preferred Stock: A hybrid between debt and equity. Preferred shareholders have a higher claim on assets than common shareholders and may receive fixed dividends, but they typically do not have voting rights.
• Retained Earnings: Profits that a company reinvests in its business rather than paying out as dividends. Retained earnings are considered part of equity since they belong to the shareholders.

2. Debt

• Senior Debt: The highest priority in the capital structure, senior debt holders are repaid first in the event of bankruptcy or liquidation. Senior debt often includes bank loans, bonds, or other secured lending.
• Subordinated Debt (Junior Debt): This debt is lower in priority compared to senior debt. In the event of default, subordinated debt holders are repaid only after senior debt holders. This debt typically carries higher interest rates due to increased risk.
• Secured vs. Unsecured Debt: Secured debt is backed by specific assets (collateral), whereas unsecured debt is not. Secured debt holders can seize the assets if the borrower defaults, while unsecured debt holders have no direct claim on the borrower’s assets.
• Convertible Debt: A type of debt that can be converted into equity (typically common stock) at a specified price or under specific conditions.

3. Leverage

• Leverage: Refers to the amount of debt a company uses to finance its operations relative to its equity. High leverage means the company has more debt compared to equity.
• Debt-to-Equity Ratio (D/E): A key measure of leverage, the debt-to-equity ratio compares the total amount of debt a company has to its equity. A high ratio indicates a heavily leveraged company, which may be riskier for investors.
• Interest Coverage Ratio: This ratio measures a company’s ability to meet its interest payments on outstanding debt. A higher ratio indicates that the company can comfortably cover its debt costs, while a lower ratio suggests financial strain.

4. Cost of Capital

• Weighted Average Cost of Capital (WACC): The overall cost of financing a company’s operations, considering both debt and equity. WACC is used to evaluate the cost of raising funds and to assess investment decisions. The lower the WACC, the cheaper it is for a company to finance its operations.
• Cost of Equity: The return that equity investors expect in exchange for providing capital. This is typically higher than the cost of debt because equity is riskier (there’s no guaranteed repayment like with debt).
• Cost of Debt: The effective interest rate a company pays on its borrowed funds. Since interest payments on debt are tax-deductible, the cost of debt is adjusted for the tax shield provided by these deductions.

5. Capital Structure Theories

• Modigliani-Miller Theorem: This theory suggests that in a perfect market, the value of a company is not affected by its capital structure, meaning that the mix of debt and equity doesn’t impact its overall value. However, real-world imperfections like taxes, bankruptcy costs, and asymmetric information affect this.
• Trade-Off Theory: This theory states that companies balance the tax benefits of debt (interest payments are tax-deductible) against the costs of potential financial distress when determining their optimal capital structure.
• Pecking Order Theory: This theory suggests that companies prefer to finance operations with internal funds (retained earnings) first, followed by debt, and lastly by issuing new equity, because new equity is often the most expensive and dilutive.

6. Capital Structure Hierarchy

• Priority of Claims: In the event of a company’s liquidation, the order of repayment is as follows:
  • Secured Debt Holders (senior debt)
  • Unsecured Debt Holders (subordinated debt)
  • Preferred Shareholders
  • Common Shareholders (last in line and most at risk)

7. Optimal Capital Structure

• The optimal capital structure is the mix of debt and equity that minimizes the company’s cost of capital while maximizing its value. Companies strive for a balance that provides enough leverage to enhance returns, without taking on excessive risk that could lead to financial distress or bankruptcy.

8. Mezzanine Financing

• A hybrid form of financing that sits between debt and equity in the capital structure. Mezzanine financing is typically used for growth or acquisitions and often includes both debt and equity features (e.g., convertible debt or debt with warrants). It provides lenders with the option to convert into equity if the company performs well.

9. Covenants

• Financial Covenants: These are conditions set by lenders that a borrower must meet to remain in good standing with their debt. They often include maintaining certain financial ratios, such as the debt-to-equity ratio or the interest coverage ratio.
• Negative Covenants: Restrictions imposed by the lender that limit the company’s activities, such as prohibiting the issuance of additional debt or limiting dividend payments until the debt is repaid.

10. Leverage Buyouts (LBOs)

• An LBO is a transaction where a company is acquired using a significant amount of borrowed money (debt). The assets of the company being acquired are often used as collateral for the loan. This type of deal is highly leveraged, and the goal is to increase the company’s profitability and pay down the debt over time.

Conclusion

Understanding capital structure is critical for businesses in managing their financial health and for investors in evaluating the risk and return potential of their investments. Key considerations include the priority of debt versus equity, the cost of capital, leverage, and the balance between risk and return. Businesses must carefully manage their capital structure to ensure they have enough flexibility to grow while maintaining financial stability.

Tom Siska

Tom‘s impressive career includes transformative successes, solidifying his stature in the financial sector. Notably, he drove impactful Sales & Marketing strategies at Sterling Commercial Credit LLC, culminating in a game-changing acquisition.

At Grasshopper Bank NA, he played a pivotal role in establishing a thriving commercial and asset-based lending group and his skill in integrating and overseeing acquisitions at North Mill Capital underlined his strategic acumen.

His talent for nurturing winning teams and delivering transformative outcomes has yielded an impressive $100MM in stakeholder value across diverse startup and turnaround ventures.