Financial Structure
The term "financial structure" refers to the specific mixture of long–term debt and equity that a company uses to finance its operations. Why it matters? The composition directly affects the risk and value of the associated business.
First, a little about the choices. Equity represents ownership in the company, usually in the form of stock. Debt represents loans.
A company doesn't have to pay back stock. There's no cost, per se. The shareholders make money when the price of the asset (the company) rises in value.
Debt has to get paid back. Also, there's a cost to having debt, in the form of interest. The company has to write regular checks to repay the debt (think about your monthly mortgage payment and you'll get the idea).
But bringing in debt doesn't dilute your ownership. The more shares sold to outsiders, the less of the company the original founders own. Sell enough equity and the company's founders no longer have much say over "their" company.
So debt and equity both have pluses and minuses. A financial structure with too much debt gets expensive. Take on too many loans, and the regular payments of interest and principal cut deeply into operating profit. The company can't afford to do much other than service the debt.
Meanwhile, weight your financial structure too far toward equity and you can cease to own "your" company.
You found a company, holding 100% of the equity. You sell half to fund expansion. Now you own 50%. You don't care too much because you're still the largest single shareholder, plus you used the money you made selling stock to expand your business. The 50% of the your new, expanded company is worth much more than the 100% of the small startup you had before.
You want another round of expansion, so you sell half your stock again. Now you own 25%. Try the process again...12.5%.
You keep going until the company itself is very big, but you own a vanishing part of it. Eventually, you get in a tiff with some members of your board and you're asked to leave (See: Steve Jobs, circa 1985).
Why take any of these risks? Because companies need money for expansion, to build factories or hire sales people. Taking on debt or selling equity allows small garage startups to become multi-billion dollar global behemoths.
But balancing the financial structure is a key concern of corporate managers. They want to keep the cost of capital down, while making sure that their shareholders don't revolt due to excessive dilution.
Related or Semi-related Video
Finance: What is a Balance Sheet?47 Views
finance- a la shmoop. what is a balance sheet? well it's a snapshot. a financial
reckoning of what you own ,and what you owe at a given moment in time. well note
that a balance sheet is divided into columns like this. on the left are good [balance sheet pictured]
things like things you own. on the right side are things you owe like debts or
obligations you have to pay off. well think for the balance sheet of little
brother Inc. you have total assets of $142 with current assets of a hundred
bucks .80 bucks of that current asset set is cash and twenty dollars is an IOU
from the tooth fairy ie dad ,who woke you up last night [clown next to child's bed]
replacing the tooth and since you're old enough you just winked and he said yeah
I'll get you a twenty from my wallet in the morning. note that if he'd said I'll
get it for you a year and change from now. it wouldn't be a current asset it
would be a long-term asset, because current means that a promise or a
product or whatever turns into cash within a year. you mowed the lawn for the [assets listed]
summer for mrs. garden bottom and billed her $500. she paid you four hundred
ninety dollars and still owes you ten bucks. that money lives in your balance
sheet on the assets side as an account receivable. you have four hundred ninety
seven little blue marbles as your only asset which your friend Billy has
offered you tons of times to buy for twenty four dollars so you can hold that [kids exchange marbles and money]
amount as inventory. it's an asset. since you know you deal in marbles regularly.
and you paid ten dollars for ten year rights to enter your sister Jeannie's
room anytime you want. you still have eight years to go on that paper so you'd
depreciate its value at a dollar a year worth eight bucks today. total everything [balance sheet shown]
up and you have that one hundred forty two dollars in assets on your own
personal balance. sheet okay so what about your liabilities. well you have
total liabilities of a hundred dollars. you owe Joe lunch bully thirty bucks to
learn why you'll stop hitting yourself. or rather to stop doing so you owe him
thirty bucks tomorrow and you know you'll owe him sixty bucks a year in
change from now maybe more in the future and maybe not if you grow and put on a [ laughing boy is offered cash]
few pounds. but you are conservative financially so you reserve that 60 bucks
as if it's a certain long-term debt, so it goes down there on
line 13 .you borrowed ten bucks from your boo
Amy the auditor for lunch she actually submitted to you an invoice. albeit
romantically. so you have ten bucks on line eight there .so you have one hundred
forty two dollars in total assets and a hundred dollars in total liabilities, but
wait they don't balance. oh no what shall we do ?well a balance sheet accounts for
this it's called ale and it stands for assets minus liabilities equals equity. [man gives thumbs up]
well you have assets $142 we just outlined and you can subtract your
liabilities which we just outline of a hundred bucks and you have net equity
value to your life of $42. it looks like little brother Inc doesn't have to worry
about filing for bankruptcy anytime in the near future which is good because
with Joe lunch bully in the picture, life is hard enough as it is. [kid frowns as bully pushes his own hand in his face]
Up Next
What is a Consolidated Balance Sheet? A consolidated balance sheet is one that includes all of the subsidiary companies’ aggregate balance sheets...
What is off balance sheet financing? Hit play to find out.