What it means
Every dollar of assets a business owns was funded by somebody, and the financial structure is simply the record of who. Owners provided equity, lenders provided debt, and suppliers and employees provided short-term credit by being paid after the work was done.
The distinction from capital structure matters more than it sounds. A company with modest long-term borrowings can still be fragile if it funds itself with a revolving overdraft and 90-day supplier terms, because those obligations can be withdrawn far faster than a five-year loan.
Debt is cheaper than equity for two reasons: lenders take less risk and rank ahead of shareholders, and interest is usually deductible against tax while dividends are not. The catch is that interest must be paid whatever happens, which is why highly geared businesses fail during downturns that merely bruise their competitors.
Matching is the practical discipline. Long-lived assets such as buildings and machinery should be funded with long-term money, and short-term assets such as stock and receivables with short-term facilities, because funding a fifteen-year asset with a one-year facility means refinancing risk every twelve months.
Structure also varies by industry for good reasons. A utility with predictable regulated cash flows can carry far more debt than a fashion retailer whose sales swing with the season, so comparing gearing across sectors without adjusting for cash flow stability is a fast route to a wrong conclusion.
In practice
Real-world examples.
Example
A regulated water utility funds 65% of its balance sheet with long-dated bonds because its revenues are set by a regulator and vary little. A software startup with the same gearing would be considered reckless, since its revenue could halve in a year.
Example
A wholesaler funds $8,000,000 of stock and receivables through a revolving facility that its bank reviews annually. When the bank cuts the limit by 30% at renewal, the business must shrink its stock holding even though it is trading profitably.
Example
A family manufacturer refuses all borrowing and funds a $12,000,000 factory extension from retained profits over seven years. The structure is safe, but a competitor that borrowed the money completed the same expansion in eighteen months and took the market share.
Formula
Calculation
Debt to equity ratio = total debt / total equity. Weighted average cost of capital = (equity share x cost of equity) + (debt share x after-tax cost of debt).
A manufacturer is funded by $30,000,000 of debt and $50,000,000 of equity, so total capital is $30,000,000 + $50,000,000 = $80,000,000. The debt to equity ratio is $30,000,000 / $50,000,000 = 0.60, and debt makes up $30,000,000 / $80,000,000 = 0.375, or 37.5% of the total, with equity at 62.5%.
Shareholders require a 12% return and the debt carries 7% interest. With a 25% tax rate the after-tax cost of debt is 7% x (1 - 0.25) = 5.25%. The weighted average cost of capital is (0.625 x 12%) + (0.375 x 5.25%) = 7.5% + 1.97% = 9.47%.
If the company replaced $10,000,000 of equity with debt, the mix would become $40,000,000 debt and $40,000,000 equity, or 50% each, and the arithmetic cost would fall to (0.50 x 12%) + (0.50 x 5.25%) = 6% + 2.625% = 8.63%. That saving is real but not free: interest cover falls, lenders will eventually demand a higher rate, and shareholders will require more than 12% to compensate for the extra risk.Case study
Seen in the real world.
The following is an illustrative and fictional example. Ardennes Packaging, an invented producer of moulded cartons, funded a $24,000,000 plant upgrade using a two-year bridging facility because the interest rate was 2 percentage points below the available long-term loan, saving about $480,000 a year.
The illustrative plant had an economic life of roughly fifteen years, so the funding and the asset were badly mismatched from the start. When the facility came up for renewal, credit conditions had tightened, the bank offered only $16,000,000 on renewal, and Ardennes had to raise $8,000,000 of equity at a valuation about 20% below where it had stood eighteen months earlier.
The fictional outcome was that the $480,000 of annual interest saving, roughly $960,000 over two years, was dwarfed by the dilution the founders took to close the gap. Ardennes eventually refinanced into a ten-year facility, and its board adopted a simple rule that no asset with a life over five years would be funded with money repayable in under five.
Watch out
Common mistakes.
- Using financial structure and capital structure as identical terms, when the first includes short-term liabilities that the second normally excludes.
- Chasing the lowest weighted average cost of capital as if it were a target, ignoring that higher gearing raises the return both lenders and shareholders demand.
- Funding long-life assets with short-term facilities because the headline rate looks better, which creates refinancing risk exactly when credit is hardest to obtain.
Questions
People also ask.
What is a sensible debt to equity ratio?
It depends entirely on how stable the cash flows are, with utilities and property comfortably above 1.0 and cyclical or early-stage businesses often below 0.5.
Does more debt always reduce the cost of capital?
Only up to a point, after which the added risk of financial distress pushes up both the interest rate demanded and the return shareholders require.
Where do trade payables fit?
They are part of the financial structure as a form of short-term, usually interest-free funding, though stretching them too far damages supplier relationships and can cost more in lost discounts than a loan would.
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