As the private markets continue to shift, dealmakers have become increasingly scrupulous when it comes to deploying capital. Regardless of their strategy, investors need a thorough understanding of the companies they’re funding. Evaluating capital structure is an essential aspect of the due diligence process that helps investors understand and mitigate risk.
Likewise, optimal capital structures benefit companies because they are more attractive to potential investors and minimize risk exposure in times of market downturns.
What is capital structure?
Capital structure refers to how a company finances its growth and operations facilitated through a mix of debt and equity. This combination can have a significant effect on financial health, performance, investments, and acquisition strategies. Determinants of capital structure vary by industry, what stage the company is in, and monetary regulations.
Why is it important?
Understanding capital structures allows investors to assess the level of financial risk associated with an investment or acquisition. Businesses with higher debt relative to equity have more leveraged capital and may have a higher risk of defaulting on their commitments, which could negatively impact the value of investors’ holdings and increase the cost of capital.
How to decode a company’s capital structure
An important resource in assessing capital structure is a company’s balance sheet, which itemizes a company’s assets and liabilities, including equity and debt—allowing you to see how much of the capital structure each represents. Though equity and debt provide a business with resources, they each have strengths and weaknesses.
Understanding the debt-to-equity ratio in financial analysis
To identify capital structure, analysts, investors, and lenders calculate the debt-to-equity ratio (D/E) by dividing the total liabilities of the enterprise by its equity. It includes existing and long-term liabilities such as loans and bonds, whereas shareholder equity equals aggregate assets minus liabilities.
The D/E ratio of a company can be helpful in quickly assessing financial risk. By placing a company’s debt in the context of shareholder equity, it’s easier to see how leveraged a company is and whether there is enough equity to cover debt obligations if necessary. Identifying capital structure is relatively simple and objective but often leads to a more qualitative or subjective assessments of a company based on whether an investor, partner, or service provider considers it to fit their risk tolerance or their perceived optimal capital structure.
The role of equity in capital structure
Equity represents shares of ownership in a company and can be exchanged with investors for capital. Its distinct advantage over capital acquired through debt is that it does not come with the expectation of being paid back. As such, equity capital can function as an insulator or backup earlier in a company’s lifecycle or during periods of stagnation or low revenue. The disadvantage of exchanging equity for capital is that the company must relinquish partial ownership.
The role of debt in capital structure
Debt consists of borrowed capital either in the form of bonds or loans. Unlike equity, debt comes with the advantage of allowing a company to retain ownership stakes but comes at the cost of future repayments and accrued interest. Despite this, many companies are still drawn to debt as an option since it is more widely available, easier to procure, and doesn’t require giving up ownership.
Why do investors need to know a company’s capital structure?
A potential investor, acquirer, or service provider needs to know about a company’s debt liabilities and equity structure to assess its enterprise value or predict the financial impact existing obligations may have on a company in the future.
In an uncertain market, well-balanced capital structures can bolster a company‘s ability to weather the storm. A company with a preferable D/E ratio may have greater access to debt financing and liquidity in general—and may be better positioned to take advantage of lower valuations to acquire distressed assets, generate value or invest in growth.
What are the different types of capital structure?
Laying the groundwork for an optimal capital structure depends on a company’s capitalization needs, cash flow viability, and financial requirements. Below, we take a closer look at some common debt and equity financing structures.
- Debt capital structure involves borrowing a fixed amount of capital with interest, spanning senior debt and subordinate debt, long-term bonds, and even credit cards. Optimal debt structure can reduce leverage through refinancing or renegotiating terms with lenders when necessary.
- Equity capital structure refers to raising funds by selling stock on the public market, resulting in greater ownership dispersion. Attracting investors and working with a smaller pool of owners are its central functions. These involve additional stock issuance, buying back shares to prevent over-dilution, and paying investor dividends.
- Mezzanine capital structure combines debt and equity financing, but prioritizes debt repayment. Mezzanine capital is leveraged when companies want to grow without issuing additional equity and can be converted into equity by the debtholder at a higher enterprise valuation.
- Hybrid capital structure mixes debt and equity and is often bought and sold by brokerage firms. This approach draws on the benefits from both capital structures, utilizing preferred equity stock with a fixed payment without voting rights.
- Vendor financing is a form of financing provided from vendor to customer and often utilized by businesses that cannot obtain a bank loan. Vendor financing spans both debt and equity but comes with a higher interest rate in debt financing.
The benefits and drawbacks of simple versus complex capital structures
Companies with simple capital structures finance through one class of equity stock, such as common stock—granting voting rights and dividend earnings. The benefits of a simple capital structure include transparency and greater control for company founders and preferred shareholders.
Shareholders have the potential for astronomical returns, but if prices plummet or in the event of a bankruptcy filing, they could lose a lot. By the same measure, the lack of access to different equity instruments and ownership diversification can increase exposure to risk.
This structure aims to avoid diluting company earnings and only reports on basic earnings per share (EPS) without citing diluted earnings per share. On the other hand, a complex capital structure contains dilutive securities, allowing shareholders to convert their shares into a fixed number of common shares after a set date or at the lender’s discretion.
Complex capital structures have the advantage of employing multiple financing instruments and are often seen in startup financing or venture-backed companies. This equity type comes with increased costs and difficulty regarding various legal due diligence requirements for debt and equity classes.
What is optimal capital structure?
Optimal capital structure seeks to increase the company’s value while reducing the cost of capital. The metric is a result of a company’s aggregate raised funds—debt and equity—estimated through the weighted-average cost of capital.
Investors and lenders can use this metric to identify their expected rate of return and compare a company’s risk profile to its peers and competitors. Information on the cost of capital—aka equity dilution and enterprise value ratio—can be critical for conducting financial analysis and informing M&A strategy.
Why is capital structure important to decision-making?
With insight into a company’s capital structure, you can identify likely buyouts, acquisition targets, and debt refinancing or recapitalization opportunities. For example, lenders can use information on capital structure to identify underleveraged companies that may be looking to take on more debt. Using details on debt interest rates and soon-to-mature debt, a lender can find public companies that may be a good fit for their services.
Why does the source of financing matter when doing financial analysis
It’s essential to understand the sources of a company’s funding since different sources of debt or equity will have different effects on the cost of capital. The kinds of debt a company has, as well as the interest rates that accompany that debt, will affect the price a potential acquirer may pay or indicate potential risks about investing in or acquiring that company.
As such, it is important to review capital structure information to understand whether a company is more skewed toward debt or equity and identify those that match the specific optimal capital structure of different investment styles or financial services.
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