Capital Structure

You need money to buy a house. The bank won't give you a loan (the result of some pesky details surrounding a land deal in Florida from a while back...no need to tell the whole story here). So now what? Wouldn't it be great if there was another option? What if you could sell stock in yourself, the way companies do? (That Florida land thing might come up there too, but you can take your chances.)

If you went public, you might not get too many buyers, but companies usually do. The fact that companies can raise funds by selling stock on the public market gives them a choice. They can choose between debt and equity (and usually use a combination of the two) in order to finance daily operations and to expand their business. This is known as their capital structure. It's the way a company has financed itself.

A given company might have $800M in debt, while raising $250M in equity and have $300M in cash on their books. Meanwhile, it has other assets, like a factory worth $425M after having been depreciated from $800M and patents worth $100M. The debt could be in the form of bank loans or it could come from issuing bonds. Equity would include common and preferred stock.

The trick in optimizing the capital structure is to find the right mixture of debt and equity, remembering that when you sell debt, you have to pay it off at some point (presumably). When you sell equity, on the other hand, you've sold ownership in yourself forever.

The right mix in the capital structure varies by context. The company's accountants and outside analysts often use a fairly simple comparison to study a company's capital structure. It's called the debt-to-equity ratio.

As the name implies, this figure provides the ratio between a company's debt and its equity. You calculate this by dividing the firm's total debt by its total equity.

One of the benefits of debt is that interest payments are tax deductible. You also don't have to give up any company ownership like you would with selling stock. With equity, you don't have to pay any money back like you would with a loan or bond issue, but you give up a piece of ownership in the company.