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What Is the Relationship between Capital Structure and Performance?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 10 July 2018
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    Conjecture Corporation
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Capital structure and performance are two business concepts that often relate closely to a company’s corporate finance department. Capital structure represents the mix of debt and equity financing a company uses to pay for large parts of business operations. Performance is often a review of how well a company meets goals and other measurements it has defined for itself. The relationship between capital structure and performance often comes when a company wants to ensure they are not paying too much for the use of external funds. This review typically involves the cost of capital paid for a mix of outside financing, which is the aggregate interest rate paid for these funds.

Large companies and organizations are typically the institutions that use a mix of debt and equity financing types. Debt can be both bank loans and bonds issued by the firm, though other debt types may be included here. Equity is usually stock offerings made to financial institutions; some equity investments made directly by an equity firm may also go here. Like all borrowed money or stock issued, companies must pay some form of interest or financial returns on these funds. Each type of money used from an external source has an attached interest rate, which is essentially the cost to use someone else’s money, again linking capital structure and performance.

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Corporate finance departments tend to heavily evaluate each type of project or other investment that requires outside funds. Financial formulas can help a company decide which type of outside funds to use based on interest rates and the length of the repayment terms for these funds. Capital structure and performance is important because small changes in the structure can result in major shifts relating to the outcomes of each project. In some cases, a single project may actually require an individual mix of bonds, debt, or equity funds in order to pay for it. Companies must ensure that each of these items added to the current capital structure does not create financial hardship on the business.

Failing to recognize the relationship of capital structure and performance on internal finances and a company’s financial statements can be devastating. First, a company can experience low cash flows for an extended time period, making it difficult to pay bills. Second, a heavy debt load on a company’s balance sheet can result in less interest from future investors or lenders. Third, more pressure is on the company to perform well, which can create undue pressure on those within a business to fudge numbers or engage in fraudulent activities. Finally, companies may be subject to more external reviews from outside regulators.

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