As a business owner or leader, the financial performance of your company is probably your number one concern. Having a sound capital structure ensures that you are using your available funds effectively and increases your market valuation. Learn about different capital sources, how to determine your capital structure, and how to know whether you have enough safety capital to stay afloat.
What is Capital Structure?
Capital structure is a corporate finance term that refers to the mix of external funding sources that a company uses to finance its operations and growth. This structure consists of the specific combination of equity, mezzanine debt, and senior debt that a corporation uses to finance its assets, and maintaining the right combination of these allows you to keep your true cost of capital as low as possible.
Depending on the complexity of the capital structure, a company may have dozens of sources that they draw on to generate the complete financing package. Capital structure is what describes the relationship of these various capital sources as they appear on the corporation’s balance sheet.
Why Is Capital Structure Important?
Understanding a corporation’s capital structure is necessary to determine which of the many available options is the most fiscally responsible to pursue and avoid. Financing with equity versus debt has different capital costs and, as such, will have significantly different long-term effects on the health of a corporation’s finances. Additionally, consideration should be given to the fact that once equity is issued it can be difficult to recall.
Capital structure matters because it influences the cost of capital, shareholder value, risk profile, and financial health of the corporation. Your ability to achieve your financial objectives, remain competitive, and enjoy long-term sustainability is rooted in maintaining an efficient and advantageous capital structure.
Capital Sources
A corporation’s capital structure may include any or all of the following capital sources:
● Senior debt
Senior debt is the first level of a corporation’s liabilities, which means it is paid out ahead of all other creditors. As opposed to junior debt, senior debt is first in seniority and is often secured by collateral in the form of a lien.
Senior debt is one of the safest forms of financing for the party providing the funds. Because of its inherent low risk, it also provides the least amount of return. However, in exchange for this low return, significant protection is provided even in the event of bankruptcy. Should a corporation go bankrupt, any remaining funds, dissolved assets, or other available sources of value must first repay senior debt before other creditors can collect.
Senior debt is financing that has been lent to a corporation for a pre-negotiated period with interest paid on the principal. The lender profits from this arrangement due to the scheduled period of borrowing on which the interest applies. The risk is low since the borrower is contractually obligated to make payments on a pre-determined schedule. The lender does not gain the benefit of a higher potential return since the financing and its recoupment is not based on the borrowers’ financial performance. For this reason, senior debt is prioritized over other investments and creditors.
● Mezzanine debt
Mezzanine debt or mezzanine capital is a hybrid form of capital that can be structured as either preferred equity or debt. This generally refers to the layer of debt that sits between senior debt and equity. Mezzanine debt lays claim to a corporation’s assets, yet also incorporates equity-based security options in its structure. It is senior only to common shares and is often a more expensive form of financing due to its positioning and higher level of risk to the lender. Unlike venture capital, mezzanine debt is best used for later-stage companies that are cash flow positive and need capital for any number of growth-related uses.
Benefits of mezzanine debt include:
- The company being funded gains capital while increasing its leverage
- The senior secured lender sees an injection of new opportunity equity and reduced leverage
- The mezzanine debt provider can put their capital to use at an attractive rate
- Shareholders avoid unnecessary dilution from new equity (which is also the most expensive form of capital)
- The company enjoys a lower cost of capital when compared to equity
- The company receives fewer rigid terms when compared to senior debt
- The company’s weighted average cost of capital (WACC) can be reduced
- The company’s return on equity (ROE) can be increased
Mezzanine debt is usually seen as a positive move for mature companies because all parties involved in the capital structure can end up benefiting. And because it is not senior debt, it comes with less stringent payment terms and is more “patient”. It is also advantageous because the desired return is 13 to 25%, which is lower than equity and helps reduce the overall cost of capital for a mature company. In fact, a company that properly incorporates mezzanine debt into its capital structure can take its Weighted Average Cost of Capital (WACC) from as high as 35% and reduce it down to 11% while moving its return on equity from only 12% up to as high as 40%.
Although mezzanine debt is a form of debt financing, it is considered hybrid capital since it may also incorporate equity instruments such as warrants. Other options such as call options and rights may also play a role. When these equity instruments and options are embedded in the debt, mezzanine debt behaves more like stock, allowing easy conversion of the debt into stock. This makes mezzanine debt attractive as it adds to the owner’s equity. More equity allows for greater flexibility when dealing with other stakeholders, thereby increasing the value of this subordinated junior debt.
When an acquisition or buyout is being transacted, mezzanine debt can be used to bridge the gap in funds and or to prioritize new owners over existing owners during the transition period. Please read our full white paper on mezzanine finance to learn more.
● Equity
Equity, also known as risk capital or share capital, describes the value of an ownership stake or interest in a property. Equity is found on the corporation’s balance sheet and is an integral element of how a business’s finances are managed and accounted for.
When a corporation is established, the owners contribute funds to help finance assets. In exchange for those funds, a liability is created on the corporation to its owners in the form of share capital. The capital that is formed is equity and it represents the sum of investments made in the corporation, typically in exchange for shares.
Shareholder’s equity is the amount of funds that have been contributed by the owners of the corporation, plus any retained earnings that have accumulated. Since losses are ultimately the responsibility of the owners, losses incurred by the corporation will negatively affect shareholders’ equity. Because equity is inherently risky, equity investors are generally looking for a minimum of a 25% return. Equity capital is considered the most expensive form of risk capital. Looking down the risk curve lower-cost options include preferred shares, convertible debentures, mezzanine debt, and senior debt.
● Working capital
Working capital (WC) is a financial metric that determines a corporation’s short-term operating liquidity and is crucial for understanding the availability of funds for necessary financial transactions related to daily operations. WC is calculated by subtracting your current liabilities from your current assets:
Working Capital = Current Assets – Current Liabilities
Examples of current assets include cash, accounts receivable, and inventory. These can be easily liquidated to raise funds. Current liabilities include accounts payable, accrued expenses, and short-term debt. A short period of negative working capital may not necessarily be a cause for concern but the circ*mstances matter. If it was because of a large order due to increased demand which increased accounts payable, it may not be a problem. A business will eventually receive the inventory and sell its products, increasing current assets in the form of cash or receivables. It can then use the cash to pay down its liabilities. However, if it is growing too fast and sales stagnate, this could be a problem. The business will still owe its suppliers but cannot sell its product fast enough to cover these obligations. A long period of negative working capital should be a red flag for most companies. It indicates an inability to meet short-term liabilities. The company is having liquidity issues and may need to borrow more or sell equity to cover its funding gap.
● Debt Alternatives
Debt alternatives are a form of debt relief such as debt restructuring or forbearance. Debt restructuring allows the renegotiation of payment terms, conditions, and payment schedules to allow the debtor a greater chance of repaying the original principal. By relieving some of the pressure of accrued interest as well as reducing the amount paid at each installment, the creditor protects themselves from a debtor at risk of defaulting on their payments and therefore increases the likelihood of having the original debt satisfied.
Debtor-on-possession (DIP) financing is used when restructuring ownership of a corporation or in the case of an anticipated bankruptcy. It is an interim form of financing that allows a firm to keep possession of its assets during the restructuring process while receiving financing to continue operations. This gives the firm a chance to become solvent again. The lender in DIP financing will often be given priority over all other claims if the turnaround is unsuccessful and the company is forced to liquidate its assets.
Debt alternatives may also be used to take advantage of lower interest rates. By taking existing debt and either renegotiating its terms or repaying its principal with funds acquired through new sources of financing, the borrowing corporation can reduce its cost of financing below the amount incurred due to the original agreement. Furthermore, a corporation may issue callable bonds that allow for such a future restructuring. The debt from those bonds may be called back when beneficial and replaced with the new, lower interest-rate debt.
How to Determine Your Capital Structure
To determine a corporation’s capital structure, you must calculate the percentage of the total funding that each component represents. By analyzing a corporation’s financial statements, we can compile a list of all the capital components on the books. Considering all the capital components that contribute to the overall capital structure, we can calculate the percentage of the total capitalization represented by each component. Deeper digging will uncover the corporation’s leverage, which is described by the ratio of debt financing to equity financing.
5 Steps to Determine Your Capital Structure
- Identify all the corporation’s capital components by examining the most recent financial statements. Compile a list of all debt and equity, including retained earnings, common shares, debt financing, and contributions.
- Calculate the total of all debt and equity you have identified. This figure should equal the net sum of all the corporation’s assets.
- Take each component of the corporate structure and divide it by the total of all components, as calculated in step 2. These figures represent what each source of capital’s percentage is relative to the total of the corporate structure.
- Use these percentages (calculated regularly) to monitor the mix of debt versus equity a corporation currently holds on its books.
- Identify relevant benchmarks for comparison.
By monitoring a corporate structure over time and incorporating mezzanine debt into the structure, an effective and fiscally responsible capital structure can be planned and achieved.
Risk Management Considerations: How Much Safety Capital is Enough?
As part of any company’s risk management strategy, the probability and severity of failure in any asset or acceleration of any liability should be assessed to determine the level of safety working capital that is needed to avoid potential liquidity shortfalls.
Bank failures (First Republic Bank, Silicon Valley Bank, WaMu, Lehman Brothers, and others) demonstrate the importance of balance sheet strength. The liquidity issues that led to the demise of these banks arose from a fundamental mismatch between the duration of assets and liabilities. This can happen to any business that is not recalibrating regularly. According to Wikipedia, liquidity is “the ability to meet obligations when they come due”. This is different from solvency, which is defined as “the ability of a corporation to meet its long-term fixed expenses.”
Liquidity can be measured using a number of financial ratios, with the most common being the ratio of current assets to current liabilities. The greater the positive delta is the more working capital and safety capital a firm has. A more detailed option is to look at the liquidity of specific assets in a business with the shortest-duration assets being the most liquid against the most immediate creditor requirements. For example, cash is more liquid than accounts receivable. The following chart illustrates some examples of liquidity with estimated duration:
Current assets and liabilities can fluctuate greatly, which makes it difficult to match the duration. Corporations that have withstood the test of time employ a surplus of liquid assets, including bank operating lines, to create a safety margin for the business. How much safety capital is required depends on the certainty of your business’s liquidity and solvency measures.
Examples of an asset failure:
- failure of a customer to pay on time
- failure of a customer to pay at all
- loss of business equipment due to an accident
Examples of acceleration of liabilities:
- legal judgments against the company
- environmental liabilities
- acceleration of debt
Most Canadian term debt facilities are due upon demand by the bank at any time. Thus, if treated in accordance with IFRS, these may be classified as a current liability that potentially adversely changes a company’s current ratio, tripping banking and other stakeholder covenants. Three to six months of excess working capital represents a good start from a safety capital perspective. This time frame varies with market conditions but is usually sufficient to liquidate some assets or seek refinancing or outside capital to recapitalize a business. If you have excess safety capital it may be prudent to acquire the premises that you operate from. Semi-illiquid real estate is well received by banks and stakeholders as collateral.
If you don’t have a strong balance sheet, fundamental mismatches between assets and liabilities can spell disaster. Most of us have used a line of credit (personal or business) to buy a longer-duration asset and are guilty of a mismatch. If you’re worried about whether or not you have enough safety capital, we can help. Contact us today for some guidance on interpreting your capital structure.
