Analyzing Corporate Capital Structure

But before I begin coverage of individual balance sheet items, I would like to address one more global issue. Global within the scope of a balance sheet, of course. Namely, the corporate capital structure.

Corporate capital structure refers to the structure of the ‘right side’ of your balance sheet. In other words, to the composition of a company's capital in terms of equity (common and preferred stock), debt (including bonds and loans) and hybrid securities (such as convertible debt). Capital structure shows how the company in question finances its overall operations and growth by using different sources of funds.

Like everything else in your company, your capital structure needs to be optimized. In this optimization project, you must address two key issues. The first one is what is called an assets/liabilities duration match. The rule – based on good old common sense – is that you finance your current assets with your short-term liabilities; and your long-term (capital) assets with long-term liabilities and shareholders’ equity.

This rule is all about two things – costs and risks. Which ultimately affect your financial value. Long-term debt is more expensive than short-term debt (because the lender takes more credit risk by lending money long-term). Therefore, if you finance your current (short-term) assets with your long term liabilities (or, God forbid, your equity), you incur unnecessary expenses that negatively affect your financial value.

If you are financing your long-term assets with your current liabilities, you are running a liquidity risk. Long-term assets are substantially less liquid than your current ones; therefore, if for some reason you fail to refinance your current liabilities and will be force to liquidate your assets to repay your short-term debt, you run the risks of serious financial losses. In most severe cases, you will not be able to pay your current debt at all. Which means going bankrupt.

The second issue is also about costs and risks. Short-term debt is less expensive but more risky. Long-term debt and especially equity is less risky, but more expensive. Both these costs and risks influence your WACC – Weighted Average Cost of Capital – that materially influences both your economic profit and your financial value.

Both extremes – high costs/low risks and low costs/high risks make your WACC too high. Higher than optimal, that is. Which negatively affects both of your corporate fundamental performance indicators - your economic profit and your financial value.

Therefore, your have two primary objective in optimizing your corporate structure: (1) to achieve an optimal asset/liability duration match and (2) make sure that your capital structure yields an optimal WACC. Typically, when you achieve the latter, you almost automatically get the former.