Capital Structure
Capital structure may be regarded as a critical parameter of a company’s performance. It refers to the type of funds an organization uses to finance its operations, assets, and the sources of this money (Titman et al., 2017). In particular, a company’s capital structure refers to its combination of equity and debt.
Equity
Equity is debt-free capital, comprising a company’s ownership rights. It may come from multiple sources, including savings, earnings, stock options, and family investments. While large businesses may fund their activities, assist with acquisitions, and support expansion through savings from previous years, thanks to productive performance and brand recognition, start-up businesses heavily rely on a higher return to attract investors.
Debt Capital
In turn, debt capital refers to borrowed money used to support the capital structure and ensure business development, which is typically returned to lenders with interest expense. Short- and long-term debts may include senior debts that should be paid back first in the event of financial struggles or bankruptcy, as well as subordinated debts with higher interest rates. These debts also include credit cards, loans, short-term commercial papers, long-term bonds, and convertible debts that may be converted into equity.
Validity
The company’s validity determines the cost of its borrowing. Thus, higher-rated and less risky organizations may expect lower interest rates, while poor financial performance and riskier behavior lead to higher rates (Titman et al., 2017). Traditionally, lenders’ decisions are based on a company’s balance sheet, demonstrating its reliability in borrowing.
Cost of Capital
The relationships between equity and debt produce one more essential parameter of organizational performance considered by investors – the cost of capital. On the one hand, it is the total cost of an organization’s funds, including debts and equities. On the other hand, as a cost of operations’ financing, the cost of capital refers to the comparison of raising money from investors or borrowing it from lenders with expected returns (Titman et al., 2017).
In other words, it is a rate of return that determines the minimum sum of money that will be returned to an investor to provide capital. For example, when a company starts a new project by attracting lenders and shareholders, the latter expect higher returns, including interest payments or dividends, compared with the cost of capital to justify their investments. In turn, the cost of capital is calculated using the weighted average cost of capital (WACC), which evaluates the cost of all debt and equity and their respective proportionate weights.
Importance of Financial Indicators to Investors
All three parameters may be essential for investors, as they demonstrate the rationale for investing in a company based on its performance reflected in the balance sheet. First, a firm’s capital structure is closely connected with the analysis of its debt-to-equity ratio. This ratio indicates whether a company primarily relies on borrowing or utilizing its own resources to finance its operations. Traditionally, companies with multiple debts have been perceived as demonstrating riskier behavior. However, other parameters may indicate the potential risks to ensure substantial growth.
Moreover, by analyzing a firm’s cost of capital and WACC, investors will understand whether their involvement will be efficient. In addition, they help determine a firm’s valuation, as high capital costs and low proceeds over long periods make investments non-valuable. Ultimately, these parameters may indicate a company’s ability to withstand periods of recession.
Reference
Titman, S., Keown, A., & Martin, J. (2017). Financial management: Principles and applications (13th ed.). Pearson.