Capital Structure and Company Life Cycle | CFA Level I Corporate Issuers
Welcome back to our CFA Level 1 study notes! Today, we’re exploring capital structure and how it evolves throughout a company’s life cycle. So, let’s jump right in.
Understanding Capital Structure
Capital structure refers to the way a company finances its assets and operations using a mix of equity and debt issuance. When discussing a company’s debt-to-equity ratios in the context of capital structure, it’s important to remember that we use market values for both debt and equity, not book values from the balance sheet. For example, if the market value of a company’s debt is $2M and the market value of its outstanding shares is $3M, we describe the capital structure as 40% debt, 60% equity, and its debt-to-equity ratio is 67%.
Capital Structure and the Company Life Cycle
Companies adopt a wide range of capital structures based on their life cycle stage. The main characteristics that influence the proportion of debt in a company’s capital structure are:
- The growth and stability of revenue.
- The growth and predictability of cash flow.
- The amount of business risk.
- The availability of debt
- The cost of debt financing.
- The amount and liquidity of the company’s assets.
In the start-up stage, sales are just beginning, and operating earnings and cash flows tend to be low or negative. Business risk is usually very high. Not many investors would lend to start-ups, and even if they are willing, they would demand high interest rates. Assets, both accounts receivable and fixed assets, are typically low and therefore not available as collateral for debt. For these reasons, start-up companies usually have close to zero debt.
When a company progresses to the growth stage, revenue rises faster, cash flows start to improve, and business risk is somewhat reduced. Some investors may be more willing to lend to the company, so debt financing costs are reduced. The company should have more substantial assets now, so the loans tend to be secured by fixed assets or accounts receivable. Depending on the company, debt issuance may be as much as 20% of the firm’s capital structure.
If a company progresses to the mature stage, revenue growth slows, but cash flows are often positive and predictable, reducing business risk. Debt financing is widely available at relatively low cost. The debt structure can be a mix of secured and unsecured bonds, and bank loans, in amounts in excess of 20% of the firm’s capital structure and sometimes significantly more than that. Over time, as a mature company earns excess income, the equity value may grow through retained earnings, causing the debt proportion to fall. If there are a lack of growth opportunities, some companies may choose to repurchase their debt using excess cash, further reducing the proportion of debt in the capital structure.
And that’s our quick introduction to capital structure and how it changes over time based on the company life cycle. In our next lesson, we’ll dive into capital structure theories. Stay tuned!