Financial Management

27Capital Structure and Financial Leverage

The capital structure of a firm is critically important for two reasons. First, it is the source of capital to finance the company's operations. Second, it is a significant factor in determining the firm's cost of capital, which was discussed in Chapter 26. In this chapter, we will explore capital structure and financial leverage in greater detail.

OVERVIEW OF FINANCING AND CAPITAL STRUCTURE

We will use the financial statements of LSA Technology Company to illustrate key aspects of capital structure and financial policy (see Table 27.1).

In Chapter 6, we suggested an alternative presentation to the traditional Balance Sheet as shown in Figure 27.1. This presentation delineates the net operating assets (or invested capital) required to support the business and the sources of this invested capital. The net assets deployed in this business are $64,755 and are funded by $10,000 in debt and $54,755 in equity.

The column on the right represents the capital structure of the firm, and the mix of debt and equity used to finance the capital requirements of the firm.

Capital Structure and Liquidity Measures

Capital structure measures are indicators of the firm's source of capital (debt vs. equity), creditworthiness, ability to service existing debt, and ability to raise additional financing if needed (see Table 27.2). Liquidity measures examine the ability of the firm to convert assets to cash to satisfy short-term obligations.