Understanding The Capital Structure of a Company

As an investor, the term 'capital structure' matters because it has implications, firstly for the operational health of the business you invest in, and secondly, for the returns you receive as an investor.

Long-term Funding Sources
Capital structure of a company refers to the mix or combination of various forms of funding for the operation of the business. Principally, they consist of long-term funding options of equity, debt and preferred stock. It is therefore simply the way a company finances its operation.

The Gearing Ratio is Important
The relationship between debt and equity in the capital structure of a company is referred to as gearing. A company with a high proportion of debt is said to be highly geared. This is also called high leverage, and the company, a highly levered or geared company. The debt/equity ratio, which is leverage, is computed by dividing total liabilities (or more strictly, interest-bearing long-term debt) by the total shareholders' equity. Each company is believed to have an optimum capital structure, at which point its cost of capital is lowest. It is part of the responsibility of management to seek to operate at close to that optimum structure.

The Equity Component
Taking a closer look at the components of the capital structure, equity represents ownership interest. It is the value of issued and paid-up capital of the business and represents the capital contribution of shareholders, inclusive of their retained earnings. Equity holders share in the profit of the business by way of dividends which include bonus issues. They however have no fixed or guaranteed returns and so, place no fixed reward obligation on the company. Their interest is residual but could be very rewarding if the company performs profitably, since there is no limit to the returns they could potentially earn. No company board and management can continue to enjoy the support and understanding of shareholders over a long period if reasonable returns cannot be generated for the shareholders.

Long-term Debt Holders
Debt holders - debenture or bonds - on the other hand, have no ownership claim, but are creditors entitled to principal repayment and a fixed claim of interest on their capital. This fixed obligation could become a burden to the company when it is unable to generate good earnings to meet the obligations. The reverse is also true: good earnings, fixed charges and the residue goes to owner shareholders. Preference shares are a hybrid, with features that lie somewhere in between. They have a fixed rate of dividend and their claim has precedence over the right of ordinary shareholders to dividend. If they are cumulative, it means that their dividend must be paid and will be carried forward as a debt if current earnings cannot accommodate payment. For regular shareholders and non-cumulative preference shares, if dividend cannot be paid in a given financial year, there is no such carry-forward.

It All Counts
As an investor, it matters when you evaluate companies for possible investment (say buying its shares), to review the capital structure to assess the degree of leverage, among other features. A highly geared company (too much debt) represents a higher risk profile and should show a returns potential that justifies it, to prove attractive. The commitment to interest payments, which are due whether or not earnings are generated, has seen several companies end up with the receiver. If a company is already immersed in undue debt exposure, its ability to raise further borrowing will be constrained. These have implications for its future performance and survival. That doesn't say precisely that you will go looking only for unlevered companies. No, it only says you need to understand the capital structure of that company and its likey implications, and along with other factors, decide if you find the investment attractive.

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