Capital structure analysis definition

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What is Capital Structure Analysis?

Capital structure analysis is a periodic evaluation of all components of the debt financing and equity financing used by a business. The intent of the analysis is to evaluate what combination of debt and equity the business should have. This mix varies over time based on the costs of debt and equity and the risks to which a business is subjected. Capital structure analysis is usually confined to short-term debt, leases, long-term debt, preferred stock, and common stock.

When to Conduct a Capital Structure Analysis

The analysis may be on a regularly scheduled basis, or it could be triggered by the upcoming maturity of a debt instrument, which may need to be replaced or paid off. Alternatively, an analysis may be required when there is a need to find funding for the acquisition of a fixed asset or another business. It may also be needed when a key investor demands to have the business buy back shares or pay out a larger dividend. It may also be useful when there is an expected change in the market interest rate.

Ratios Used in Capital Structure Analysis

It can be helpful to calculate several ratios as part of a capital structure analysis. Here are some of the more useful ratios for this work:

  • Debt ratio. The debt ratio measures the proportion of assets paid for with debt. A high ratio implies that the bulk of company financing is coming from debt; this is a risky financial structure, since the borrower is at risk of not being able to pay for the associated interest expense or paying back the principal. A low debt ratio reflects a conservative financing strategy of using only equity to pay for assets.

  • Debt to equity ratio. The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs.

  • Interest coverage ratio. The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. A high ratio indicates that a company can pay for its interest expense several times over, while a low ratio is a strong indicator that a company may default on its loan payments.

Related AccountingTools Courses

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Contents of a Capital Structure Analysis

When engaging in a capital structure analysis, consider the following questions:

  • Impact on covenants. How does the current or projected capital structure impact any loan covenants, such as the debt to equity ratio? If the effect is negative, it may not be possible to acquire any additional debt, or existing debt may need to be paid down.

  • Debt paydowns. Are there any expensive tranches of debt that can be paid down? This involves a discussion of alternative uses for any available cash, which could be more profitably employed elsewhere.

  • Alternative uses of cash. Are the uses for cash within the company's business beginning to decline? If so, does it make more sense to return cash to investors by buying back shares or issuing more dividends?

  • Need for restructuring. Are the company's financial circumstances so difficult that it will be more difficult to obtain loans in the future? If so, does it make sense to restructure operations to improve profitability and thereby reopen this financing alternative?

  • Stock price positioning. Does the investor relations officer want to establish a floor for the company's stock price? This can be achieved by engaging in an ongoing stock repurchase program that is triggered whenever the stock price falls below a certain amount.

  • Bond rating goal. Does the company want to achieve a certain rating for its bonds? If so, it may need to restructure its financing mix to be more conservative, thereby improving the odds of investors being repaid by the company for their purchases of the company's bonds.