What is Capital Structure?

Capital structure is the mix of debt and equity that a business uses to fund its operations. A firm’s capital structure may contain many components, including common stock, multiple classes of preferred stock, bonds, debt having different terms and maturity dates, and retained earnings. All of these components of a firm’s capital structure can be discerned from its balance sheet and associated disclosures.

The precise types of debt and equity included in a firm’s capital structure dictate the cost of capital and the amount of risk that management is willing to take on. For example, management may be willing to use a high proportion of debt financing in order to reduce its cost of capital, but doing so increases the risk of bankruptcy, since the firm is at risk of being unable to fulfill its debt repayment obligations.

What are the Components of Capital Structure?

A business may have quite a complicated capital structure, with many components. Here are the main components that a business may have:

Common stock. Common stock is an ownership share in a corporation. The holders of common stock have voting rights at shareholder meetings and the opportunity to receive dividends. If the corporation liquidates, then common stockholders receive their share of the proceeds of the liquidation after all creditors and preferred stockholders have been paid.
Preferred stock. This is a class of equity ownership that has a more senior claim on the earnings and assets of a business than common stock. In the event of liquidation, the holders of preferred stock must be paid off before common stockholders, but after secured debt holders.
Senior debt. This is collateralized debt, which means that the lender can take certain assets that were itemized in the lending agreement if the business cannot pay it back. Because of the security of senior debt for the lender, it typically has a lower interest rate.
Junior debt. This is debt that is only paid back after all senior debt has been paid back. Given this positioning, there is an increased risk that the debt will not be paid back, so it is likely to carry a higher interest rate than senior debt.