Definition of the financial structure
What is the financial structure?
Financial structure refers to the combination of debt and equity that a business uses to finance its operations. This composition directly affects the risk and value of the associated business. The company’s CFOs 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 referred to as the capital structure. In some cases, the assessment of the financial structure may also include the decision between running a private or public company and the capital opportunities that accompany each.
Understanding the financial structure
Companies have several choices when it comes to setting up the commercial structure of their business. Companies can be private or public. In each case, the framework for managing the capital structure is essentially the same, but the financing options differ greatly.
Overall, the financial structure of a business centers around debt and equity.
Debt principal 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 their equity which can take the form of market value gains or distributions. Every business has a different mix 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 the two. 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 selected investors rather than the public market of an exchange. As such, the fundraising process is very different from a formal initial public offering (IPO). Private companies can also go through multiple rounds of equity financing over time, which affects their market valuation. Companies that mature and choose to issue shares on the public market do so with the support of an investment bank that helps them pre-market the offering and value the initial shares. All shareholders are converted to public shareholders after an IPO and the company’s market capitalization is then valued based on the outstanding shares multiplied by the market price.
Debt capital follows similar processes in the credit market, with private debt mainly offered only to selected investors. In general, state-owned enterprises are followed more closely by rating agencies, with public ratings helping to rank debt investments for investors and the market as a whole. Corporate debt securities take precedence over equity for private and public companies. Even though it helps to get into debt with less risk, private market companies can still expect to pay higher interest rates because their operations and cash flows are less established, which increases risk. .
Debt vs. equity
In building the financial structure of a business, financial managers can choose between debt or equity. Investor demand for both classes of capital can strongly influence a company’s financial structure. Ultimately, financial management seeks to finance the business at the lowest possible rate, reducing its capital obligations and allowing greater capital investment in the business.
Globally, financial managers consider and assess the capital structure by seeking to optimize the weighted average cost of capital (WACC). The WACC is a calculation that derives the average percentage of payment required by the company to its investors for all of its capital. A simplified determination of WACC is calculated using a weighted average methodology that combines the distribution rates of all of the company’s debt and equity.
Metrics for financial structure analysis
The key parameters for analyzing the financial structure are mainly the same for private and public companies. State-owned companies are required to file public documents with the Securities and Exchange Commission, which provides investor transparency in the analysis of financial structure. Private companies generally only provide financial reports to their investors, which makes their financial report more difficult to analyze.
The data for calculating measures of capital structure usually come from the balance sheet. A primary measure used in assessing financial structure is debt to total capital. This gives a quick overview of the company’s share of debt and share of equity. Debt can include all of a company’s balance sheet liabilities 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 debt a business becomes.
The debt to equity ratio is also used to identify capital structuring. The more a company is in debt, the higher this ratio will be and vice versa.
Key points to remember
- Financial structure refers to the combination of debt and equity that a business uses to finance its operations. It can also be known as the 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 mix of debt and equity.
- Debt to capital and debt to equity are two key ratios that are used to better understand the capital structure of a business.