Capital Structure: Definition, Formula, and Importance

Capital structure is a corporate finance term that describes the funds companies use to pay for their operations and assets. These funds appear on the company’s balance sheet and consist of equity capital, amount of debt, and preferred stock.

If you’re a business owner, your goal is to achieve optimal capital structure, defined in financial management as the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for your company.

You can calculate your company’s capital structure by examining your debt-to-equity ratio, which you determine by dividing your liabilities (level of debt) by your total equity. The difference between your assets and liabilities determines your working capital or the amount of liquidity (current cash flow) you have. If the ratio exceeds 1.0, your company has more debt capital than equity financing.

Before you calculate your business’s capitalization ratio, you’ll need to identify the following dollar values for your company:

• Equity capital: Equity capital is the money supplied by your stakeholders in the form of contributed capital (investments in your company through stock shares or ownership) or retained earnings (profits from past years).
• Debt capital: Debt capital is money you borrow from debt holders and lenders, which may be in the form of a mix of debt, such as long and short-term loans from capital markets, credit cards, and long-term bonds. Vendors can also finance debt capital by allowing you to sell goods before requiring repayment.

Once you’ve determined the dollar valuation of your equity and debt, apply the following calculation:

Debt-to-capitalization ratio = dollar amount of debt / dollar amount of capitalization

Identifying and monitoring your firm’s capital structure benefits and informs you as a business owner in multiple ways:

• Assessing company growth: Your financial risk declines as your company grows from a start-up to a functioning business. Your operations become more predictable and profitable, improving access to new income sources such as debt financing. You can assess the growth of your business through capital structure.
• Ownership and interest: Equity financing means investors have ownership rights in your company and receive a portion of the earnings. If the company earns nothing, the investors also earn nothing. Debt financing means you own your company, but you’ll have to pay the money borrowed back to lenders, including an interest rate, even if your company fails. Each has risks and rewards, and a capital structure helps you manage these options.
• Seeking investors: Growth means your company has a higher market value and stock prices, attracting more dependable lending providers with lower interest payments. If your company has more debt than equity, investors will see it as a more significant financial risk. Your company’s capital structure guides you in terms of when and from whom to seek investments. Get Starbucks CEO Howard Shultz’s tips for finding business investors.

MasterClass at Work is the learning platform to help unlock the full potential of your employees and inspire a learning lifestyle in everyone. From negotiation to mindfulness to baking—these are just a few things your teams can explore.