Definition
Capital structure comprises debt and equity employed by a business. It states the specific amount of these components that a company uses to finance its assets and fund its operations. A company's capital structure is expressed through these ratios: debt-to-equity or debt-to-capital.Companies use their debt and equity capital structure to fund day-to-day operations, acquisitions, investments, etc. There is always a tradeoff between these two components and finance managers help in balancing the two to ensure an optimal capital structure.
Example
A company's capital structure gives details of its debt and equity break-up. Some of the components that can be seen in a capital structure include common equity, long-term debt, short-term liabilities, preferred equity, etc.With the right mix of debt and equity, a business can carry out its operations smoothly and achieve growth. For example, a company's capital structure may constitute 40% long-term debt, 50% common stock, and 10% preferred stock.
Why it matters
Capital structure is important since it can impact a company's stability while conducting business. Here are some of the other reasons why it matters:1. A sound capital structure offers better potential to increase the company's valuation.2. A good capital structure ensures that the company has sufficient funds available to be used effectively. 3. It can prevent under or over-capitalization.4. A company can increase its profits through a well-planned capital structure5. It helps in maximizing shareholders’ capital and minimizes the cost of the capital.6. With a good capital structure, companies can enjoy the flexibility of raising or reducing debt capital depending on the business need.