Capital Structures Essentially, There Are Really Only

Capital Structures

Essentially, there are really only two ways in which organizations can raise money -- debt or equity. The core of this comes down to cash flow for each type of financing. A debt claim, for instance, allows the holder to a set of cash flow, typically principle and interest; an equity claim entitles the holder to any leftover cash after meeting all other claims. Secondly, debt has prior claim on cash flow and assets. This complicates the matter of the way debt is managed and analyzed when looking at different industries. For instance, debt as a percentage of the market value of equity in an airline would be different than one in say, electronics -- all dependent upon a variety of inventory and supply/demand, price elasticity ratios.

Organizations that have high debt-equity ratios seem to be the ones that have longer term, or higher cost-based services; or those that are more fleeting and seasonally driven. Production and marketing costs figure into this ratio as well.

b. Leveraged debt is not necessarily bad; nearly every business has cycles; the less debt that must be serviced, the more likely the business will survive. High leverage is typical for startup and early stage business, too; but companies like construction organizations with long-term projects must leverage and hope that once the project is done, there is money to be made.

c. Equity and equity ratios play a part in the way bankers and stakeholders look at a given business. The longer the track record for a high leveraged business, the more it looks like a good investment. Future earnings are based, as well, on the types of business and the commodities that are used to make up the product. Life cycle, resources, demand, and structure all play a part in the equation and the way future earnings are projected. A hotel chain, for instance, might be highly leveraged and seasonal, but if it has been in business in a popular area for 10 years, then small bumps in consumer demand have a smaller overall affect than those in a glitzy new resort.

Part 2 -- Debt Ratios

The optimal fiscal structure of a company is one in which there is an appropriate mix of debt and equity financing that tends to maximize the value of the organization to stakeholders. This value, of course, is directly related to the stock price of the company on the open market. So, the optimal capital structure is the mix of debt and equity that maximized AT&Ts public stock price.