Capital structure
Also known as: financial structure, capitalization
Capital structure is the mix of debt and equity a company uses to fund its assets and operations. The balance between borrowed money and owners' capital determines a firm's financing cost, its financial risk, and the order in which claims are paid.
A company's capital structure describes where its long-term funding comes from. On one side sits equity — ordinary shares, preference shares, and retained earnings — which represents ownership and carries no obligation to repay. On the other sits debt — bank loans, debentures, and bonds — which must be serviced with interest and repaid on a fixed schedule.
The two sources behave very differently. Interest on debt is a contractual expense that is generally tax-deductible, making borrowed money cheaper than equity in good times. But that same contractual obligation must be met whether or not the company earns a profit, so heavy borrowing magnifies both gains and losses for shareholders. Equity is more expensive and dilutes ownership, yet a company can suspend an ordinary dividend without defaulting.
Analysts measure the balance with gearing (leverage) ratios — for example, debt divided by debt plus equity, or debt divided by equity. A firm financed 70% by debt is highly geared: small changes in operating profit swing earnings per share sharply, and lenders view it as riskier. Capital structure also fixes the priority of claims in a liquidation, where secured lenders rank ahead of unsecured creditors, who rank ahead of preference shareholders, who rank ahead of ordinary shareholders.
Capital structure appears throughout professional accounting syllabuses. The ACCA Financial Accounting exam covers how share capital, reserves, and loan finance are recorded and how finance costs flow through the statement of profit or loss, along with the gearing ratios used to interpret them. CMA Part 1 draws on capital structure when building pro forma financial statements and projections.
Key takeaways
- Capital structure is the combination of debt and equity financing a company uses.
- Debt is cheaper because interest is tax-deductible, but it creates fixed obligations that increase financial risk.
- Gearing ratios measure the proportion of debt in the structure; higher gearing amplifies returns and losses alike.
- Capital structure sets the ranking of claims on liquidation, with lenders paid before preference and ordinary shareholders.