The capital structure of a company refers to the type of funds used to finance the company and the source of those funds. The capital structure can impact the return that the company achieves for its shareholders. It can also determine whether the company will survive a recession or economic downturn.
What is it and why does it matter?
The term “capital structure” refers to the ratio of capital (funds) used in the business of the company by type. Generally, it comes in two types: equity capital and debt capital.
Each type of capital has its advantages and disadvantages. It is essential to maintain a balance to sustain business growth. Creating a capital structure that provides the ideal balance between risk and reward for shareholders is a significant part of prudent company management and sustainability.
Equity Capital
Many owners fund new businesses with their own money, which can come from their savings. Sometimes the funding comes from family members. Retirement plans may be utilized. One common source of funding for startups is private equity.
Private equity refers to the funds contributed by shareholders, who thus become owners. This type of capital comes in two forms.
Common Equity
This is the money invested in the company in exchange for shares of stock or ownership. Common equity can come from shareholders. It may also come from angel investors or venture capitalists.
Angel capital and venture capital are considered rare and hard to access. Angels fund less than 3% of new startups. Venture capital funds less than 1%. These types of funding force owners to give up some degree of control over their businesses in return.
Retained Earnings
This type of capital is the profits from previous years retained by the company and used to strengthen the budget. It can also fund growth and acquisitions or expansions.
Equity capital can be the most expensive type of capital a company can use. This is because its “cost” is the return that the company must achieve to attract investment.
Debt Capital
Debt capital in a company’s capital structure refers to borrowed funds that operate within the company. Its cost depends on the financial health of the company. A company with a AAA rating can borrow at very low rates. In contrast, a high-risk company with a lot of debt may have to pay 15% or more for debt capital.
There are different types of debt capital.
Loans or Credit Cards
Many companies start by obtaining loans from family or putting expenses on credit cards. Many also apply for loans from banks or the Small Business Administration (SBA). Small banks can be good sources of funding for new businesses.
Long-term Bonds
This is generally considered the purest form of debt because the company has years, even decades, to repay the principal. At the same time, it only pays interest.
Short-term Commercial Papers
Used by giants like Walmart and General Electric, these can reach billions of dollars in overnight loans from financial markets. They can help meet daily working capital requirements such as payroll and utility bills.
Vendor Financing
In this case, the company can sell goods before having to pay the invoice to the vendor. This can significantly increase the return on capital, but it costs the company nothing. One of Sam Walton’s secrets to success at Walmart was selling Tide detergent before having to pay the invoice to Procter & Gamble. In fact, he was using Procter & Gamble’s money to grow his business.
Insurance
Funds
They are used by insurance companies, and they are funds that do not belong to the company. They can be used or earn interest on them until the company has to pay them.
Pursuit of an Ideal Capital Structure
Many middle-class investors have a goal to be debt-free. When it comes to a company’s capital structure, there are more factors to consider.
Many of the most successful companies in the world base their capital structures on one simple consideration – the cost of capital. The DuPont model can provide further insight.
Suppose you can borrow money at a rate of 7% for 30 years. The inflation rate is 3%. You can reinvest that money into core operations with a return of 15%. This is a reason to go into debt. It would be wise for your capital structure to contain at least 40% to 50% of debt capital, especially if your sales and cost structure is completely stable.
If you are selling a basic product, debt will be much less of a risk compared to if you were managing a tourist city at the peak of a booming market. Here is where management talent, experience, and wisdom come into play.
The best managers have a talent for continuously lowering the weighted average cost of capital by increasing productivity, seeking higher-yielding products, wisely using debt, and more.
Source: https://www.thebalancemoney.com/an-introduction-to-capital-structure-357496
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