Understanding Capital Structure: Part 1
Understanding Capital Structure: Part 1
In Part 1 of this capital structure series, we examine debt and equity: the two components that make up the capital structure, and the advantages and disadvantages associated with each.
Decisions, decisions…When a company decides how to finance their operations and future growth, the options ultimately boil down to either debt or equity. Companies can choose to be heavily leveraged with debt, primarily financed with equity, or a combination of both. This combination of debt and equity is known as the capital structure and it is an important metric that investors, creditors, regulators, analysts and Chartered Business Valuators frequently utilize.
In this blog we examine the two components that make up the capital structure: debt and equity, and the advantages and disadvantages associated with each.
Debt
Debt is a financial liability (obligation) that is owed by one party, the ‘debtor’, to another party, the ‘lender’. The most common forms of debt are loans: a party receives a set amount of money, which must be repaid within a set time frame. Typically, these loans include an interest component that the debtor must pay in addition to the principal payments. This interest portion compensates the lender for the risk they incur by issuing the loan.
Equity
Equity financing is the process of obtaining financing through the issuance of shares: effectively selling ownership of the company in return for capital. Through equity financing the company can generate the needed capital (money) that is used to grow and build the company while the investor can obtain ownership and share in the future profits of the company. Equity financing can be through the sale of common shares, preferred shares, convertible shares and other equity instruments.
Advantages vs. Disadvantages
When a company is tackling the difficult decision of what financing route would be the most beneficial for their business, they will often examine the advantages and disadvantages for both debt and equity financing.
What are some of the common advantages and disadvantages a company may take into consideration?
Debt Financing
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| Advantages | Disadvantages |
| Shareholders retain their ownership interest | Principal and interest payments can strain cash flow |
| Interest payments on the loans are tax deductible, reducing taxes payable | Company must qualify to obtain a bank loan |
| Likely the cheapest form of financing given it is the least risky for lenders/investors | Special terms may include covenants, audited/reviewed financial statements and security requirements |
| Cater to company’s needs giving them flexibility of securing short-term, medium term, or long-term financing | Interest rates offered depend on the state of the economy, and high interest rates could eat up working capital |
Equity Financing
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| Advantages | Disadvantages |
| No financial burden on the company (i.e. no interest/principal payments) | Dilutes ownership of existing shareholders and decreases earnings per share |
| A viable option when a company lacks creditworthiness to secure debt financing | Generally, more expensive than debt given the increased risk |
| Investors can bring a valuable level of expertise to aid management | Investors may not work well with existing management |
| Long-term financing beneficial to fund growth, new projects, or revamp operations | Often more difficult and time consuming to find an investor instead of a lender |
Debt vs. Equity
It is important to understand that debt generally has a lower cost than equity, as equity investors require a higher rate of return to compensate them for the risks related to ownership. Debt financing incorporates aspects such as payment schedules, interest rates, covenants, security requirements and has priority of payout should liquidation of the company occur, which all decrease the risk associated with this type of financing.
Now that we understand that companies can choose to finance with debt or equity, the real question is, what is the specific weighting of debt and equity that provides a company with the greatest benefit? This theory is known as optimal capital structure and indicates the specific mix of debt and equity that factors into the weighted average cost of capital (WACC), which we will discuss in Part 2 of this series.
If you would like a further discussion on capital structure or your company’s specific situation, please do not hesitate to call our team.
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