Capital Structure Definition, Types, Importance, and Examples

Learn about the capital structure definition, factors, types, importance, and examples to decide the best funding option for your business.
2 min
24-June-2024

What is capital structure?

Capital structure refers to how a company chooses to finance its operations and growth through a combination of debt and equity. Equity capital represents ownership in the company, entitling shareholders to a portion of future profits and cash flows. It can include common stock, preferred stock, or retained earnings. On the other hand, debt is obtained through bond issues or loans, which the company must repay over time with interest. Short-term debt is also considered part of the capital structure. By determining the right mix of debt and equity, companies aim to optimise their cost of capital while maximising shareholder value. This strategic balance helps manage financial risk and leverage opportunities for growth, ensuring sustainable funding for business activities. For business owners seeking financing, understanding the implications of different capital structure choices is crucial, particularly when evaluating options like unsecured loans that don't require collateral.

How does a capital structure work?

Capital structure works by determining the proportion of debt and equity financing a company uses to fund its operations and investments. This decision is influenced by factors such as the company's risk tolerance, cost of capital, and financial goals. By leveraging debt, a company can benefit from the tax deductibility of interest payments and potentially lower its cost of capital. However, too much debt can increase financial risk and affect the company's ability to meet its obligations. Equity financing, on the other hand, dilutes ownership but does not require periodic interest payments, offering more flexibility in challenging economic conditions.

Types of capital structure

The primary purpose of analysing the capital structure of a company is to determine how to allocate funds between equity and debt financing to optimise the company’s overall cost of capital. Here are the different types of capital structure:

Equity capital

Equity capital is capital raised by issuing shares in the ownership of a business. In return, shareholders are entitled to a share in the profit and a portion of the assets if the company goes out of business. Equity financing can come from existing shareholders or new investors.

Debt capital

Debt capital is the most common capital structure in most organisations and includes taking out loans from creditors like banks, credit unions, or bondholders. The borrower promises to repay the debt with interest. Debt financing can be an excellent option for businesses that have a stable cash flow.

Hybrid capital

Hybrid capital, also known as mezzanine financing, is capital structured that combines both equity and debt financing. Hybrid capital usually grants the lender the right to purchase equity in the borrower, making it a quasi-equity investment. This financing involved higher costs than other financing options but is less risky than equity financing.

Optimal capital structure

Optimal capital structure refers to the mix of debt and equity financing that maximises a company's value by minimising the cost of capital. It involves determining the right balance between debt and equity to achieve financial goals like reducing the cost of capital, maximising returns and cash flow, and ensuring financial flexibility. By having an optimal capital structure in place, the company can maintain its financial stability and achieve sustainable growth while keeping its shareholders and investors happy.

Importance of capital structure

  • Cost of capital: Determining an optimal capital structure helps minimize the overall cost of capital, balancing the expenses associated with debt and equity financing.
  • Financial flexibility: A well-defined capital structure provides financial flexibility by allowing companies to access different sources of funding based on their specific needs and market conditions.
  • Risk management: Properly structuring debt and equity helps manage financial risk by spreading it across various stakeholders and optimizing the company's risk-return profile.
  • Tax benefits: Utilizing debt in the capital structure offers tax advantages through deductible interest payments, reducing the company's tax liabilities and enhancing profitability.
  • Shareholder value: Maintaining an appropriate capital structure contributes to enhancing shareholder value by optimizing the balance between debt and equity financing to maximize returns.

Factors to consider while choosing the optimal capital structure

Several factors influence a company's optimal capital structure, including:

  • Size of the business
  • The nature of the business
  • Industry standard
  • Current and projected cash flow
  • Current leverage ratio

Therefore, before seeking a business loan, business owners must understand their company's capital structure's pros and cons. While debt financing may offer lower interest rates, equity financing is beneficial for growing a business from scratch.

Explain capital structure with example

Capital structure refers to the mix of different sources of funds, including equity and debt, used by a company to finance its operations and investments. It represents the way that a company finance its assets and is essential in determining its financial health and risk profile. For instance, a company may have a capital structure of 60% equity and 40% debt, indicating that 60% of its funds are raised through equity, and 40% through debt. This balance affects the company's cost of capital, profitability, and ability to withstand financial challenges, making it a critical aspect of financial decision-making.

How do you calculate capital structure?

The capital structure of a company can be calculated using the following formula:

Capital structure = Debt / (Debt + Equity)

Here, "debt" refers to the total amount of debt financing used by the company and "equity" refers to the total amount of equity financing used by the company.

The calculation of the capital structure can help the company determine its financial leverage and decide on the optimal mix of debt and equity to achieve its financial goals.

Why do companies have different capital structure?

Companies adopt different capital structures based on their industry, financial health, and growth objectives. Capital-intensive industries like manufacturing often use more debt to finance expensive equipment and facilities, aiming to leverage assets for growth. In contrast, technology or service sectors may prefer equity financing to retain flexibility and avoid heavy interest payments. The optimal mix of debt and equity helps balance risk and cost of capital, influencing strategic decisions on expansion, profitability, and shareholder value.

How do managers decide on capital structure?

Managers analyse various factors to determine an optimal capital structure. They calculate the weighted average cost of capital (WACC), considering costs of debt, equity, and preferred stock. By balancing financial risk and profitability, managers seek to minimise WACC, ensuring efficient capital utilisation. Factors influencing decisions include market conditions, investor preferences, and regulatory requirements. Strategic goals, such as expansion or debt repayment capacity, also guide capital structure decisions, ensuring sustainable growth and financial stability.

How do analysts and investors use capital structure?

Analysts and investors evaluate a company's capital structure to assess financial health and risk. Excessive debt may signal higher default risk, affecting credit ratings and interest rates. Conversely, high equity ratios may indicate underutilisation of leverage for growth. Optimal capital structure aligns with industry norms, ensuring competitive advantage and financial resilience. Analysts interpret ratios like debt-to-equity to gauge solvency and profitability, informing investment decisions. Understanding capital structure dynamics helps anticipate market responses, guiding portfolio diversification and risk management strategies.

Conclusion

Capital structure is a fundamental concept in finance, and it plays a critical role in a business's success. Business owners must consider various factors before making an informed decision on their optimal capital structure. Once a business has found its ideal financing mix, business owners can use the benefits of each financing option to grow and scale their business without limitations. Always consult with trained professionals in financial analysis for guidance on analysing the financial statements of the company before finalising a decision on the financing mix.

Bajaj Finserv App for All Your Financial Needs and Goals

Trusted by 50 million+ customers in India, Bajaj Finserv App is a one-stop solution for all your financial needs and goals. 

You can use the Bajaj Finserv App to: 

  • Apply for loans online, such as Instant Personal Loan, Home Loan, Business Loan, Gold Loan, and more.
  • Explore and apply for co-branded credit cards online.
  • Invest in fixed deposits and mutual funds on the app.
  • Choose from multiple insurance for your health, motor and even pocket insurance, from various insurance providers.
  • Pay and manage your bills and recharges using the BBPS platform. Use Bajaj Pay and Bajaj Wallet for quick and simple money transfers and transactions.
  • Apply for Insta EMI Card and get a pre-approved limit on the app. Explore over 1 million products on the app that can be purchased from a partner store on No Cost EMIs.
  • Shop from over 100+ brand partners that offer a diverse range of products and services.
  • Use specialised tools like EMI calculators, SIP Calculators 
  • Check your credit score, download loan statements and even get quick customer support—all on the app.

Download the Bajaj Finserv App today and experience the convenience of managing your finances on one app.

Do more with the Bajaj Finserv App!

UPI, Wallet, Loans, Investments, Cards, Shopping and more

Disclaimer

1. Bajaj Finance Limited (“BFL”) is a Non-Banking Finance Company (NBFC) and Prepaid Payment Instrument Issuer offering financial services viz., loans, deposits, Bajaj Pay Wallet, Bajaj Pay UPI, bill payments and third-party wealth management products. The details mentioned in the respective product/ service document shall prevail in case of any inconsistency with respect to the information referring to BFL products and services on this page.

2. All other information, such as, the images, facts, statistics etc. (“information”) that are in addition to the details mentioned in the BFL’s product/ service document and which are being displayed on this page only depicts the summary of the information sourced from the public domain. The said information is neither owned by BFL nor it is to the exclusive knowledge of BFL. There may be inadvertent inaccuracies or typographical errors or delays in updating the said information. Hence, users are advised to independently exercise diligence by verifying complete information, including by consulting experts, if any. Users shall be the sole owner of the decision taken, if any, about suitability of the same.

Frequently asked questions

What are the types of capital structure?

There are primarily two types of capital structure: Equity capital structure: In this type, the company raises funds by selling shares to shareholders. It does not involve any repayment obligation, but shareholders become partial owners of the company and have voting rights. The company's profits are shared with shareholders as dividends.
Debt capital structure: This involves raising funds by borrowing money through loans or issuing bonds. The company is obligated to repay the borrowed amount along with interest to lenders within a specified period. Debt financing allows the company to apply funds but increases financial risk due to interest payments and potential bankruptcy in case of default.

What does capital structure mean?

Capital structure is a term used to describe the various resources a company uses to finance its operations and growth. Sources can encompass debt, equity, and retained earnings. These choices impact the company's financial health, cost of capital, and growth prospects, among other factors and require equilibrium and prudence.

What are the three main parts in a capital structure?

The three main parts of capital structure are debt, equity, and hybrid securities. Debt represents the borrowing obligation of the firm, equity entails shares issued in the company, and hybrid securities are a combination of debt and equity securities. A robust and balanced capital structure is fundamental in enhancing financial stability and profitability.

Additional Read: Capital budgeting
Additional Read: Types of working capital
Additional Read: Capital finance