What is optimal capital structure?
Written by Michael Feder
Reviewed by听Kathryn Uhles, MIS, MSP,听Dean, College of Business and IT
Capital structure is an essential indicator of a business鈥檚 financial health as it defines the mix of debt and equity used to finance a company鈥檚 operations. Whether you learn this while pursuing an business degree or on the job, it鈥檚 critical to understand how it relates to cash flow.
Why is finding the optimal capital structure important?
Every business possibility is unique and therefore requires its own optimal capital structure to thrive, including debt, equity and other cash flows. Choosing the most effective mix of different capital sources helps businesses increase their value, distribute profits to owners or shareholders, and maintain听financial flexibility for profitable, long-term viability.
This enables a business to match its financing needs with its goals and operations, providing it with optimal performance and taking advantage of any new opportunities in the future.
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, it can be determined by measuring the effectiveness of the different financing combinations for increasing potential returns versus any associated risks.
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鈥檚 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鈥檚 necessary to understand what听听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鈥檚 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听issuing bonds or selling shares听in the company to investors.
What is equity capital?
Equity capital听is money companies raise by selling shares of their business to investors. Equity capital can come in many forms, including:
- Stocks
- Revenue
The听听is that, unlike debt capital, it does not have to be repaid. In addition, when the company鈥檚 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鈥檚 operations remain profitable. Furthermore, equity investors are typically entitled to a portion of the business鈥檚 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. 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 as well. The company must consider its current and future financial needs and ensure that it can 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鈥檚 specific needs
When it comes to optimal capital structure, a company鈥檚 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鈥檚 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.
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.
Learn more about optimal capital structure and other essential business concepts
If you鈥檙e looking to learn more things like optimal capital structure, consider one of the听business programs听at 果冻视频.
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 果冻视频 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,听Kathryn Uhles has served 果冻视频 in a variety of roles since 2006. Prior to joining 果冻视频, Kathryn taught fifth grade to underprivileged youth in Phoenix.
This article has been vetted by 果冻视频's editorial advisory committee.听
Read more about our editorial process.
Free Business Programs Guide
Make informed decisions with inside details about our business programs, the skills you鈥檒l earn, the faculty who鈥檒l teach you and more.
Free Business Programs Guide. Please enter your first and last name.
Thanks for requesting the Business Programs Guide
Download PDF now. Or access the link in our email.