Any time you’re dealing with money, things can get confusing, especially when it comes to capital structure.
What is it? Why should you use debt? In this article, you’re going to learn the answers to the above questions and so much more. Buckle up for this crash course in capital structure.
What is It?
Capital Structure can best be defined as the way a firm finances its overall operations and growth. Capital structure refers to the percentage of capital at work in a business. The source of the funding comes from different sources: long-term debt, specific short-term debt, common equity, and preferred equity. There are two types of capital: equity and debt.
- Equity capital – This is money that’s put up and owned by the shareholders in a company. There’s contributed capital, which is money that was initially invested into the company in return for a percentage of ownership in the company or stock, and then there’s retained earnings, which represents profits the company made from previous years that has been retained by the company. The retained earnings are typically used to fund acquisition or expansions.
- Debt capital – This refers to money that has been borrowed that’s in the business. Long-term bonds are obviously the safest because the company has a long time to come up with the principal while only paying the interest.
Why Should You Use Debt?
You may be wondering why debt is used in capital structure. How can having debt be helpful to a company? There are several ways debt is helpful in terms of capital structure.
Debt Lowers Financing Costs
Well, it’s essential for a company to have capital, and of the choices, debt is preferred over equity since debt has a lower financing cost. This is why companies mix debt into their capital structure. Companies make occasional interest payments and return debt principal at maturity. Debt holders are also less risky than equity holders.
If a company fails and goes into liquidation, debt holders have the first right to all company assets, which gives them more protection for their investment. If you’re looking to learn more about mixing debt into your capital structure, contact someone with experience. Check out Scott Gelbard’s executive profile and see if he can be of any assistance.
Debt Lowers Your Company’s Taxes
Because of allowable interest deductions, debt will help lower your company’s taxes. Thanks to tax rules, interest payments can be used as expense deductions against revenues to arrive at taxable income. The lower the taxable income is for that company, the less taxes a company will have to pay.
Debt Gives You Financial Leverage
Debt is desirable because of the financial leverage it provides. If a company uses debt to get additional capital for their business, equity owners would get to keep extra profit that’s generated by the debt capital after any interest payments. Equity investors have a higher return on equity thanks to the additional profits that are provided by the debt capital.
Debt Retains Profits
Equity requires the sharing of company profits with equity holders, but debt helps retain more profits. Companies only need to pay the amount of interest out of their profits when using debt. If they decide to use equity, they have to share profits with equity investors. The more they make, the more they share. The smartest thing to do is to use debt to fund stable business operations where they can make ongoing payments and keep the rest of the profits instead of sharing them with equity holders.
As you can see, capital structure is comprised of various funding resources, and the most advantageous funding source is debt. Ordinarily, debt would be considered bad. However, as listed above, debt provides some desirable advantages when it comes to growing your company. Do you run a business? If so, what does your capital structure look like? Have you taken advantage of debt? Leave a comment below and let us know!
