What Is Financial Structure?
Financial structure refers to the mix of debt andequitythat a company uses to finance its operations. This composition directly affects the risk and value of the associated business. The financial managers of the business have the responsibility of deciding the best mixture of debt and equity for optimizing the financial structure.
In general, the financial structure of a company can also be referred to as the capital structure. In some cases, evaluating the financial structure may also include the decision between managing a private or public business and the capital opportunities that come with each.
Understanding Financial Structure
Companies have several choices when it comes to setting up the business structure of their business. Companies can be either private or public. In each case, the framework for managing the capital structure is primarily the same but the financing options differ greatly.
Overall, the financial structure of a business is centered around debt and equity.
Debt capital is received from credit investors and paid back over time with some form of interest. Equity capital is raised from shareholders giving them ownership in the business for their investment and a return on their equity that can come in the form of market value gains or distributions. Each business has a different mix of debt and equity depending on its 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 equity. Private equity is created and offered using the same concepts as public equity but private equity is only available to select investors rather than the public market on a stock exchange. As such the equity fundraising process is much different than 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 in the public market do so through the support of an investment bank that helps them to pre-market the offering and value the initial shares. All shareholders are converted to public shareholders after an IPO and the market capitalization of the company is then valued based on shares outstanding times market price.
Debt capital follows similar processes in the credit market with private debt primarily only offered to select investors. In general, public companies are more closely followed by rating agencies with public ratings helping to classify debt investments for investors and the market at large. The debt obligations of a company take priority over equity for both private and public companies. Even though this helps debt to come with lower risks, private market companies can still usually expect to pay higher levels of interest because their businesses and cash flows are less established which increases risk.
Debt versus Equity
In building the financial structure of a company, financial managers can choose between either debt or equity. Investor demand for both classes of capital can heavily influence a company’s financial structure. Ultimately, financial management seeks to finance the company at the lowest rate possible, reducing its capital obligations and allowing for greater capital investment in the business.
Overall, financial managers consider and evaluate the capital structure by seeking to optimize the weighted average cost of capital (WACC). WACC is a calculation that derives the average percentage of payout required by the company to its investors for all of its capital. A simplified determination of WACC is calculated by using a weighted average methodology that combines the payout rates of all of the company’s debt and equity capital.
Metrics for Analyzing Financial Structure
The key metrics for analyzing the financial structure are primarily the same for both private and public companies. Public companies are required to file public filings with the Securities and Exchange Commission which provides transparency for investors in analyzing financial structure. Private companies typically only provide financial statement reporting to their investors which makes their financial reporting more difficult to analyze.
Data for calculating capital structure metrics usually come from the balance sheet. A primary metric used in evaluating financial structure is a debt to total capital. This provides quick insight on how much of the company’s capital is debt and how much is equity. Debt may include all of the liabilities on a company’s balance sheet or just long-term debt. Equity is found in the shareholders’ equity portion of the balance sheet. Overall, the higher the debt to capital ratio the more a company is relying on debt.
Debt to equity is also used to identify capital structuring. The more debt a company has the higher this ratio will be and vice versa.
Key Takeaways
- Financial structure refers to the mix of debt and equity that a company uses to finance its operations. It can also be known as capital structure.
- Private and public companies use the same framework for developing 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 gain insight into a company’s capital structure.
FAQs
Financial structure refers to the mix of debt and equity that a company uses to finance its operations. It can also be known as capital structure. Private and public companies use the same framework for developing their financial structure but there are several differences between the two.
How do you determine financial structure? ›
Determine the shape of your jaw.
Your jawline shape can further determine your face shape—if it's short or rounder, your face is round. If your jawline is pointy and narrow, your face is heart-shaped. If you have a strong jawline with sharp angles, that's further evidence your face is square.
How to calculate financial structure? ›
You can calculate your company's capital structure by examining your debt-to-equity ratio, which you determine by dividing your liabilities (level of debt) by your total equity. The difference between your assets and liabilities determines your working capital or the amount of liquidity (current cash flow) you have.
How to make a financial structure? ›
4 Steps to structure your company's financial planning
- Make a budget forecast. ...
- Understand the company's costs. ...
- Understand and record your financial transactions. ...
- Control and reduce expenses.
Structured finance is a financial instrument available to large financial institutions or companies that have complex financing needs that cannot be ordinarily solved with conventional financing. It is used to manage risk and develop financial markets for complex emerging markets.
How do you structure finances? ›
- Review Your Budget Monthly.
- Use a Financial App.
- Keep Bills in One Place.
- Pay Bills the Day You Get Them.
- Use a Checklist for Bills You're Expecting.
- Coordinate with Significant Others.
- Verify that Your Paycheck is Direct Deposited.
- Use Two Bank Accounts.
Some main factors include the firm's cost of capital, nature, size, capital markets condition, debt-to-equity ratio, and ownership. However, these factors might help to choose an appropriate capital structure for a business, but checking all the side factors can help adopt more appropriate and accurate adaption.
What is analysis of financial structure? ›
The Financial Structures analysis test assesses candidates' knowledge of the different financing options (debt, bonds, capital increase, etc.), their comparative advantages and the actors involved in choosing a financial structure.
What is the structure of a financial statement? ›
On the top half you have the company's assets and on the bottom half its liabilities and Shareholders' Equity (or Net Worth). The assets and liabilities are typically listed in order of liquidity and separated between current and non-current. The income statement covers a period of time, such as a quarter or year.
What is the financial structure of a small business? ›
The term financial structure refers to the precise mix of debt and equity that fuels your organization. In other words, it is the delicate balance of long and short-term liabilities combined with shareholder's or owner's equity as shown on your balance sheet, next to your assets.
What Is Optimal Capital Structure? The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility.
What is the difference between capital structure and financial structure? ›
Capital Structure is a combination of different types of long-term sources of funds. Financial Structure is a combination of different types of long-term as well as short-term sources of funds. The Capital Structure is a part of the Liabilities section of the Balance Sheet.
What is an example of financial structure? ›
Imagine you are embarking on a home renovation project that needs funds to implement your design plans. Your financial structure is analogous to determining the portion of the project cost you will fund with your savings (equity) versus the amount you borrow from the bank (debt).
What is the conclusion of financial structure? ›
In conclusion, financial structure is the blueprint that shapes a company's financial landscape. It encompasses the mix of debt and equity, the cost of capital, and the sources of funds that fuel a company's operations and growth.
What is financial structuring? ›
Definition. Structuring is the act of parceling what would otherwise be a large financial transaction into a series of smaller transactions to avoid scrutiny by regulators and law enforcement.
How do you describe a business structure? ›
A business structure refers to how a business is organized, according to its legal status. Your business structure will state who owns the company, how its profits are distributed, how it will be taxed, and what roles will perform which tasks.
What is the best way to describe finance? ›
What is Finance? Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting.
What do you mean by structure of the financial system? ›
What is the structure of the financial system? The structure of the financial system includes financial institutions such as banks, insurance companies, and mutual funds, financial markets such as stock exchanges and bond markets, and regulatory bodies such as the Reserve Bank of India.
What is the financial structure of a business organization? ›
The financial structure comprises various sources of capital for your business. It includes short-term liabilities, short-term debt, long-term debt, and equity. A company can use any or all of these instruments in unique proportions to fund its long-term and short-term working capital requirements.
