How to determine the optimal capital structure of a company
Written by Michael Feder
Reviewed by Kathryn Uhles, MIS, MSP, Dean, College of Business and IT
Capital structure is an essential indicator of a business’s financial health as it defines the mix of debt and equity used to finance a company’s operations. Whether you learn this on the job, while pursuing an online business degree or even during your master’s in business administration degree program, it’s critical to understand how optimal capital structure relates to cash flow.
Optimal capital structure is a ratio of available cash-flow sources from financial markets. It involves a complex assessment of capital costs from both debt and equity sources, and it entails evaluating such factors as interest rates, credit ratings, optimal tax policy, potential bankruptcy behaviors and expected returns for management and shareholders.
Ultimately, an optimal capital structure can be determined by measuring the effectiveness of the different financing combinations for increasing potential returns versus any associated risks.
Why is finding the right capital structure important?
An optimal combination of different sources of capital, including debt, equity and other cash flows, can give a company the best chance of success.
Every business possibility is unique and therefore requires its own optimal capital structure to thrive. Choosing the most effective mix of different capital sources helps businesses increase their value, distributions to owners or shareholders, and financial flexibility for profitable, long-term viability.
An optimal capital structure enables businesses to match their financing needs with their goals and operations, providing them with optimal performance and taking advantage of any new opportunities in the future.
Types of capital
Capital structure comprises two main categories: debt capital and equity capital. Debt capital, also known as borrowed capital, is the portion of a company’s financing that comes from borrowing funds through loans or bonds. Equity capital, on the other hand, is the money raised by selling shares in the company to investors.
What is debt capital?
To further understand the importance of capital structure, it’s necessary to understand what debt capital is. Debt capital is money companies borrow from lenders and use to finance their operations and create debt equity.
Examples of debt capital include:
- Bonds
- Loans from banks
- Credit cards and other types of borrowing
Debt capital can also include cash advances or lines of credit issued by suppliers. The advantage of debt capital is that it generates a regular income stream for the company through interest payments that can pay shareholder dividends and other expenses.
The downside of debt capital is the financial risk that comes from the fact that companies must pay back what they borrow with interest. This can be difficult if business operations are not profitable or interest rates rise. Companies must also consider the potential risks associated with borrowing, such as bankruptcy and other financial difficulties that arise if debts are not paid back on time.
It’s important to note that debt capital does not always come from traditional sources like banks or other lenders. Companies may also raise debt capital by issuing bonds or selling shares in the company to investors.
What is equity capital?
Equity capital is money companies raise by selling shares of their business to investors. Equity capital can come in many forms, including:
- Stocks
- Revenue
The advantage of equity capital is that, unlike debt capital, it does not have to be repaid. In addition, when the company’s stock rises in value, equity owners share in the reward.
The downside of equity capital is that it does not generate a regular income stream like debt capital. Thus, it must be used more wisely to ensure that the company’s operations remain profitable. Furthermore, equity investors are typically entitled to a portion of the business’s profits, which may reduce potential returns for management and shareholders.
How to determine optimal capital structure
When considering an optimal capital structure, businesses must consider their debt capacity and equity potential. In addition, they need to understand what type of financing is most cost-effective for them and how much they can realistically repay without straining the business.
Businesses should also consider balancing risk and reward when deciding on an optimal capital structure. To determine the optimal capital structure, companies should assess the costs and benefits of different financing sources, such as debt, equity or other alternative forms of capital. Beyond this, there are other substantial considerations.
Sustainability
Sustainability should be taken into account when determining optimal capital structure. The company must consider its current and future financial needs and ensure that its capital structure enables it to continue operations and meet these needs.
By understanding what debt and equity capital are, as well as the costs and benefits of each type of financing, companies can develop an optimal capital structure that will enable them to finance their operations in a cost-effective and sustainable way. This will ensure the company can remain profitable and grow.
Company’s specific needs
When it comes to optimal capital structure, a company’s overall financial situation and structure play an important role. How it earns and spends money will deeply influence which debt instruments, equity instruments and cash resources are optimal for the company’s use of funds.
For example:
- Companies with strong capital allocation strategies may be better equipped to select and manage debt instruments.
- Companies with complex businesses may need more sophisticated capital structures involving debt and equity capital.
- Smaller companies or those in the early stages of development will likely require simpler capital structures to maximize returns and minimize risk. In these cases, companies should focus on affordability and sustainability when determining their optimal capital structure.
Overall, companies and entrepreneurs must assess their current financial situations, goals and needs, and the capital resources available to them from financial markets to determine an optimal capital structure. By considering all these factors, businesses can ensure they are making wise investments and financing decisions that will enable them to remain profitable and grow long term.
This article is not intended to serve as financial advice. All financial decisions, including investments, should be made carefully and potentially with the guidance of a financial planning professional.
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ABOUT THE AUTHOR
A graduate of Johns Hopkins University and its Writing Seminars program and winner of the Stephen A. Dixon Literary Prize, Michael Feder brings an eye for detail and a passion for research to every article he writes. His academic and professional background includes experience in marketing, content development, script writing and SEO. Today, he works as a multimedia specialist at University of Phoenix where he covers a variety of topics ranging from healthcare to IT.
ABOUT THE REVIEWER
Currently Dean of the College of Business and Information Technology, Kathryn Uhles has served University of Phoenix in a variety of roles since 2006. Prior to joining University of Phoenix, Kathryn taught fifth grade to underprivileged youth in Phoenix.
This article has been vetted by University of Phoenix's editorial advisory committee.
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