What is Financial Structure?

Financial structure is the combination of debt and equity that a business has taken on. The exact mix and type of debt and equity instruments used impacts the risk taken on by a business. For example, a large debt load at a high interest rate increases the risk that a firm will not be able to pay interest to its lenders, or to pay back the principal. Given this risk, a company’s senior managers are usually quite interested in the firm’s financial structure, and try to achieve of mix of funding that is relatively low-cost, while also being relatively low-risk.

Components of Financial Structure

An organization’s financial structure may be comprised of short-term liabilities, short-term debt, long-term debt, and equity. The equity component can include a mix of common stock and preferred stock. The holders of common stock may expect recurring dividend payments, which increases the financial obligations of the business. In addition, preferred stock may have a fixed percentage dividend rate associated with it, which must be paid.

How to Measure Financial Structure

The most common way to measure financial structure is by comparing the relative proportions of debt and equity, using the debt-to-equity ratio. To calculate the debt to equity ratio, simply divide total debt by total equity. In this calculation, the debt figure should include the residual obligation amount of all leases. The formula is as follows:

(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio

Advantages and Disadvantages of a Financial Structure

A significant reliance on debt funding allows shareholders to achieve a higher return on investment, since there is less equity in the business. However, this financial structure can be risky, since the firm has a large debt obligation that must be paid. A firm positioned as an oligopoly or monopoly is best able to support such a leveraged financial structure, since its sales, profits and cash flows can be reliably predicted. Conversely, a business positioned in a highly competitive market cannot support a high degree of leverage, since it experiences volatile earnings and cash flows that could cause it to miss debt payments and trigger a bankruptcy filing. A business in this latter position needs to skew its financial structure in the direction of more equity, for which there is no payback requirement. Consequently, one of the most critical issues for a CFO to deal with is the proper mix of debt and equity to employ in a company’s financial structure.