Capital Structure - Debt & Equity Mix

What is Capital Structure

A capital structure is the mix of a company's financing which is used to fund its day-to-day operations.  These source of funds can originate from equity, debt and hybrid securities.  The equity will come in the form of common and preferred stocks.  The debt is broken out into long-term and short-term debts.  Lastly hybrid securities are a group of securities that are a combination of debt and equity.

When analyzing a company it is important to note their mix of debt and equity, because it gives a firm picture of the financial health of the company.  The higher the company's debt-to-equity ratio the greater the risk of a potential investment.

What is the Best Debt to Income Ratio

Many financial advisors will tell you that a person that after paying all of their bills each month, there should be a minimum of 10% left over for savings.  Its up to the person to figure out what items constitute their debt, but the bottom-line is the person should have 10% in cash.  The same logic applies to companies as well.  This is because each industry has different business models and even within a specific industry each company has its own way of doing things.  This is why its important to look at how a company's capital structure shifts over time.  In theory, regardless of where the capital structure mix starts, it ultimately should shift towards less debt and more cash on hand.

Financial Managers and Capital Structure Theory

Financial managers are responsible for the financial well being of a corporation.  This does not mean that the financial manager should not take risks, but rather take risks that will lead to future gains for the company.  One of the key components for taking out debt, is to attempt to take out debt which is tax deductible.  A little harder than finding tax deductible interest options is to assess the financial risk with a loan.  This requires using a number of financial ratios and forecasting tools to estimate if its a good financial decision.