The capital structure describes how a company finances its assets. Capital structure is usually a combination of several sources of mezzanine debt, senior debt and equity. Some companies use the right combination of mezzanine debt, senior debt and equity to minimize their true cost of capital. Depending on the complexity of the company’s structure, in fact, there may be a lot of sources of financing, including the use of funds from various entities to generate a complete financing package. The capital structure can be used to describe the relationship between these sources of financing and the company’s balance sheet. Besides that, how capital structure works?
For the example, if the company ABC has completed initial public offering and bond issuance, it could say that company ABC’s capital structure includes equity and debt. The retained earnings, bank loans, preferred stock and working capital might also a part of company’s capital structure. In many cases, discussions of the capital structure may include references to the debt-to-equity ratios. This is one of several ratios that measure the relative weight of different types of capital.
Next, the term of the capital structure refers to the percentage of the capital (money) at work in a business by type. Generally speaking, there are two different forms of capital as equity capital and debt capital. Equity capital is refers to that portion of the organization’s capital, which is can raised in exchange for the share of the ownership in the company and this shares are called the equity shares. The equity holders are the owners of companies that have significant control over their management. Equity shareholders are enjoy the rewards and assume the responsibility of the risk of ownership. However, their liability is limited to the amount of their capital contributions to that companies. The Equity Capital is also called as equity financing or share capital. Debt capital is when a company borrows funds to repay on a future interest date, it is called debt financing. It can be in the form of secured loans and unsecured loans. The company uses loans to fund working capital or acquisitions. Different types of capital impose different types of risks for companies. In addition, capital structure may affect the value of the company, and a lot of analysis is needed to determine the optimal capital structure of the company. For example the Fortune 500 companies and small business owners, they are trying to determine where their start-up funds should come from without endangering the business.
After that, the capital structure describes the amount of debt used by the company rather than equity, usually measured by the ratio of debt to equity. The more corporate debt, the more creditors use these funds. However, the more debt the company assumes, the more cash it generate sales. The challenge is to find the right balance between debt and equity in the optimal capital structure and then use this capital structure to grow the business. The advantages of the capital structure have Greater Control and Flexibility, Framework for Negotiation, Equity Advantages
And Amplifies Return-on-Equity.
The theory and the limitation of capital structure will be further discuss in the following.