Capital structure

What it means

Capital structure is the mix of equity and borrowed funds a company is financed with. It determines how much risk the owners carry and how much the creditors do, and how expensive the whole capital base is for the company.

Debt is usually cheaper: a bank asks for a lower return than an owner, and interest is deductible, so the state bears part of the cost of debt. Equity is more expensive because the owner carries the most risk, but it does not have to be repaid even in bad years.

The weighted average cost of both sources is expressed by WACC. A sensible structure minimises it. Too little debt means an unused tax shield and slower growth; too much raises the risk of insolvency and the price of further loans.

How it works in practice

In small and medium-sized companies the capital structure is often accidental: share capital from formation, retained earnings and one bank loan. When a client plans a larger investment, we compare financing it with a loan, a lease, a shareholder contribution or a combination.

Banks look mainly at the equity ratio and leverage. Where equity is low, we recommend considering converting a shareholder loan into a contribution to equity, which improves the company’s picture without new money.

Financing from related parties comes with tax limits. The thin capitalisation rules restrict how much interest paid to related lenders is deductible, and the interest must be at the usual market rate.

What to watch out for

A common mistake is financing long-term assets with short-term money such as an overdraft. When sales dip, the bank does not renew the facility and the company has nothing to repay it with. Long-term assets should be covered by long-term capital.

The second risk is paying dividends that cut equity to a minimum just before a loan application or under an equity covenant. Decisions on dividends should take the financing plans for the coming years into account.