What is capital structure?
– Capital structure is the mix of a company’s long-term funding sources — primarily debt (loans, bonds) and equity (shares owned by investors). It shows how a firm finances operations, growth and fixed obligations. The mix affects risk, return, tax treatment and control.
Why it matters
– The capital structure signals how much leverage (borrowing) a company uses. A leveraged firm may generate higher returns for shareholders in good times but carries greater risk in downturns because interest and principal payments are fixed. A firm funded mainly with equity tends to be less risky in terms of mandatory cash outflows but dilutes ownership and future profits.
Key definitions and formulas
– Total debt: short-term + long-term borrowings (including bonds and bank loans).
– Total equity: shareholders’ equity shown on the balance sheet (paid-in capital + retained earnings, etc.).
– Total assets: everything the company owns (balance-sheet total).
Common ratios (with formulas)
– Debt ratio = Total debt / Total assets
– Debt-to-equity (D/E) = Total debt / Total equity
– Debt-to-capital = Total debt / (Total debt + Total equity)
– Interest coverage ratio = EBIT (earnings before interest and taxes) / Interest expense
Notes on formulas
– These assume on-balance-sheet amounts and standard accounting definitions. Off-balance-sheet items (operating leases, unconsolidated obligations), contingent liabilities and different accounting regimes can change the picture.
Trade-offs investors should know
– Why firms use debt:
– Interest is typically tax-deductible (reduces taxable income).
– Debt does not dilute ownership or voting control.
– When borrowing costs are low, debt can be a cheaper source of capital.
– Downsides of debt:
– Fixed payments are required regardless of earnings — this magnifies bankruptcy risk in downturns.
– High leverage reduces financial flexibility.
– Why firms use equity:
– No mandatory periodic payments; dividends can be reduced or skipped.
– Safer in volatile revenue environments.
– Downsides of equity:
– Dilutes existing owners’ stakes and claims on future profits.
– Can be more expensive over the long term if the company performs well.
Industry patterns
– Capital structures vary by sector. Capital-intensive, stable businesses (utilities, infrastructure) commonly carry higher debt levels because cash flows are predictable and assets can secure borrowing. Tech and high-growth companies tend to carry less debt and rely more on equity, since revenues are more uncertain and investors expect growth.
Real-world behavior
– Large, cash-rich companies sometimes borrow anyway. Borrowing can be attractive for tax reasons, to preserve cash for strategic flexibility, or to lock in low interest rates for planned investments. Conversely, firms in sudden revenue collapses (for example, airlines during the pandemic) may struggle with heavy fixed-interest obligations.
Checklist: How to assess a company’s capital structure
1. Gather the basics: total debt, total equity, total assets, EBIT, interest expense.
2. Calculate key ratios: debt ratio, D/E, debt-to-capital, interest coverage.
3. Compare to industry peers and historical averages.
4. Check debt composition: short-term vs long-term maturities, covenants, secured vs unsecured.
5. Review liquidity: cash on hand and near-term free cash flow to meet interest and principal.
6. Look at credit ratings and recent financing activity (new bonds, refinancing).
7. Consider off-balance-sheet obligations and accounting treatments (leases, pensions).
8. Align findings with the company’s strategy and macro context (rates, growth prospects).
Worked numeric example
Assumptions (simple, illustrative):
– Total assets = $500 million
– Total debt = $150 million
– Total equity = $350 million
– EBIT = $50 million
– Interest expense = $10 million
Calculations:
– Debt ratio = 150 / 500 = 0.30 → 30%
– D/E = 150 / 350 ≈ 0.429 → 0.43 (company has about $0.43 of debt per $1 of equity)
– Debt-to-capital = 150 / (150 + 350) = 150 / 500 = 30%
– Interest coverage = 50 / 10 =
= Calculations (continued)
– Interest coverage = 50 / 10 = 5 → the company earns five times its annual interest expense (also called “times interest earned”).
Additional simple ratios (useful to compute)
– Equity ratio = Equity / Total assets = 350 / 500 = 0.70 → 70% (fraction of assets financed by shareholders)
– Leverage (assets-to-equity) = Total assets / Equity = 500 / 350 ≈ 1.43
– Debt / EBIT = 150 / 50 = 3 → debt equals three years of current EBIT (a rough leverage-duration proxy)
Interpretation (simple, illustrative)
– Debt ratio 30% and equity ratio 70%: relatively conservative capital structure; majority financing via equity.
– D/E ≈ 0.43: the company has about $0.43 of debt per $1 of equity — modest leverage.
– Interest coverage = 5: the company generates operating earnings five times interest costs, which is generally comfortable; agencies and lenders often look for coverage well above 1–2x to be safe.
– Debt / EBIT = 3: if EBIT fell substantially the firm could face stress; this highlights the usefulness of stress-testing earnings and cash flow.
– Caveats: these are headline metrics. They ignore taxes, capital expenditures, working capital needs, off-balance-sheet items (leases, pensions), debt maturities, covenant terms, and industry norms.
Quick stress tests (worked numeric examples)
– If EBIT falls 30%: EBIT → 50 × 0.70 = 35 → interest coverage = 35 / 10 = 3.5 (still positive but weaker).
– If interest expense rises to 15 (e.g., higher rates or new debt): coverage = 50 / 15 ≈ 3.33.
– Combined stress (EBIT 35, interest 15): coverage = 35 / 15 ≈ 2.33 → margin for error narrows; covenants or refinancing risk may increase.
Practical next steps checklist for capital-structure analysis
1. Compare these ratios to industry peers and sector medians (capital intensity varies a lot).
2. Analyze the debt schedule: maturities by year, fixed vs. floating rate, amortization profile.
3. Review covenant language in debt agreements for liquidity triggers or restricted payments.
4. Examine liquidity buffers: cash, undrawn revolvers, working-capital cycle.
5. Check credit ratings and recent financing activity (issuances, refinancings).
6. Adjust for accounting treatments and off-balance liabilities (capitalized leases under ASC 842, pensions).
7. Run sensitivity scenarios on EBIT, interest rates, and capex to assess refinancing and covenant risk.
8. If estimating WACC, calculate market-value weights and use forward-looking cost-of-capital inputs.
Assumptions and limitations
– These numbers are illustrative and simplified (no taxes, depreciation, capex, or cash-flow modeling).
– Use EBITDA rather than EBIT for many leverage comparisons if depreciation/amortization materially differs across firms.
– Always verify balance-sheet classifications, recent footnote disclosures, and management commentary in filings.
Sources for further reading
– Investopedia — Capital Structure: https://www.investopedia.com/terms/c/capitalstructure.asp
– U.S. Securities and Exchange Commission (EDGAR) — public company filings: https://www.sec.gov/edgar/search/
– Financial Accounting Standards Board (FASB) — standards and guidance (e.g., leases, pension accounting): https://www.fasb.org
– S&P Global Ratings — methodology and credit criteria: https://www.spglobal.com/ratings/en/
– Board of Governors of the Federal Reserve System — interest-rate and macroeconomic data: https://www.federalreserve.gov/
Educational disclaimer
This is educational material, not individualized financial advice or a recommendation to buy or sell securities. Always consult a licensed financial professional before making investment
decisions. This material is for education only; it is not a substitute for personalized advice from a licensed professional. Past performance is not indicative of future results; investments carry risk, including loss of principal.
Additional reputable sources
– NYU Stern — Aswath Damodaran (corporate finance and valuation resources): https://pages.stern.nyu.edu/~adamodar/
– Organisation for Economic Co-operation and Development (OECD) — corporate governance and business finance studies: https://www.oecd.org/corporate/
– Bank for International Settlements (BIS) — research on corporate debt and financial stability: https://www.bis.org/
– International Monetary Fund (IMF) — analysis of corporate sector balance sheets and macro risks: https://www.imf.org/
Educational disclaimer (reiterated): This content is educational and general in nature. It does not constitute legal, tax, or investment advice. Consult qualified professionals before making decisions based on this material.