Capital structure refers to the mix of debt and equity financing a company uses to fund its operations. Capital structure ratios tend to fall within a narrow range within industries. Managers, therefore, use industry capital structure ratios as a guide for optimizing their own company's capital structures. An optimal capital structure maximizes a company's return on invested capital and minimizes the company's credit, default and bankruptcy risks. Investors and creditors also use capital structure ratios as an input in their financial models, making capital structure a critical metric with real-world implications.
Identifying Debt
Capital structure is expressed as debt-to-equity, or debt-to-invested capital, where invested capital equals debt plus equity. Debt is equal to all interest-bearing debt, which you can find on the balance sheet in the current liabilities and other liabilities sections. If the financial statements, including the balance sheet, are audited, the footnotes accompanying them should identify the company's debt instruments, along with descriptive information, such as interest rates and maturities. Some balance sheets break out long-term debt in its own section, making it easy to identify. Do not include accounts payable as debt, nor any trade payables or accrued expenses. Mortgages, notes payable, lines of credit and capitalized leases are all debt items.
Calculating Capital Structure Ratios
Shareholders' equity is provided as a discrete line item on the balance sheet. Therefore, once you have obtained total debt, you can easily calculate debt-to-equity or debt-to-invested capital. For example, assume total debt equals $100 and total equity equals $200. This means that invested capital equals $300. Therefore, the debt-to-equity ratio equals $100 in total debt divided by $200 in total equity, or 50 percent. Likewise, debt-to-invested capital equals $100 in total debt divided by $300 in invested capital, or 33.3 percent. These are the two measures of capital structure.