What is the financial structure?
Financial structure refers to the combination of debt and equity that a company uses to finance its operations. This composition directly affects the risk and the value of the associated company. The company’s financial directors are responsible for deciding on the best mix of debt and equity to optimize the financial structure.
In general, the financial structure of a business can also be called the capital structure. In some cases, the assessment of the financial structure may also include the decision between running a private or public enterprise and the investment opportunities that arise from it.
Understanding the financial structure
Companies have several choices for setting up the commercial structure of their business. Businesses can be private or public. In each case, the capital structure management framework is essentially the same, but the financing options are very different.
Overall, a company’s financial structure is centered on debt and equity.
Debt capital is received from credit investors and repaid over time with some form of interest. Equity is raised from shareholders, which gives them ownership of the business for their investment and a return on equity that can take the form of market value gains or distributions. Each business has a different combination of debt and equity depending on their needs, expenses and investor demand.
Private versus public
Private and public companies have the same framework for developing their structure but several differences that distinguish them. Both types of companies can issue shares. Private equity is created and offered using the same concepts as private equity, but private equity is only available to select investors rather than the public market. As such, the equity fundraising process is very different from a formal initial public offering (IPO). Private companies can also go through several equity financing cycles over time, which affects their market assessment. Companies that reach maturity and choose to issue shares on the public market do so thanks to the support of an investment bank which helps them to market the offer and to value the initial shares. All shareholders are converted to public shareholders after an initial public offering and the company’s market capitalization is then evaluated on the basis of the shares in circulation multiplied by the market price.
Debt capital follows similar processes in the credit market, with private debt mainly offered only to certain investors. In general, SOEs are followed more closely by rating agencies, with public ratings helping to classify debt investments for investors and the market as a whole. A company’s debt securities take priority over the equity of private and public companies. While this helps the debt to present lower risks, private market companies can still expect to pay higher interest levels because their businesses and cash flows are less established, which increases the risk.
Debt against equity
In building the financial structure of a business, financial managers can choose between debt or equity. Investor demand for both types of capital can strongly influence the financial structure of a business. Ultimately, financial management seeks to finance the business at the lowest possible rate, reducing its capital obligations and allowing for greater capital investment in the business.
Overall, financial managers examine and assess the capital structure with a view to optimizing the weighted average cost of capital (WACC). The WACC is a calculation which derives the average percentage of payment required by the company to its investors for the whole of its capital. A simplified WACC determination is calculated using a weighted average methodology that combines the repayment rates of all of the company’s debt and equity.
Measures for the analysis of the financial structure
The key parameters for analyzing the financial structure are mainly the same for private and public companies. Public companies are required to file public documents with the Securities and Exchange Commission, which ensures transparency for investors in the analysis of the financial structure. Private companies generally only provide financial reports to their investors, which makes their financial communication more difficult to analyze.
The data for the calculation of the capital structure parameters generally come from the balance sheet. A main measure used to assess the financial structure is debt relative to total capital. This gives a quick overview of the company’s share of debt and equity. Debt can include all liabilities on a business’s balance sheet or just long-term debt. Equity is found in the equity portion of the balance sheet. Overall, the higher the debt-to-capital ratio, the more a business depends on debt.
Debt on equity is also used to identify capital structuring. The more debt a company has, the higher the ratio and vice versa.
Key points to remember
- Financial structure refers to the combination of debt and equity that a company uses to finance its operations. It can also be called capital structure.
- Private and public companies use the same framework to develop their financial structure, but there are several differences between the two.
- Financial managers use the weighted average cost of capital as the basis for managing the combination of debt and equity.
- Debt to capital and debt to equity are two key ratios that are used to better understand a company’s capital structure.