Capital structure refers to the particular combination of debt and equity used by a company to finance its overall operations and growth. Debt comes in the form of bond issues or loans, while equity may come in the form of common stock, preferred stock, or retained earnings. Short-term debt is also considered to be part of the capital structure. The debt-to-equity (D/E) ratio is useful in determining the riskiness of a companys borrowing practices. The optimal capital structure of a firm is often defined as the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC) for the firm. The trade-off theory of capital structure tells us that managers should seek an optimal mix of equity and debt that minimizes the firm’s weighted average cost of capital, which in turn maximizes company value. In reality, many practical considerations affect capital structure and the use of leverage by companies, leading to wide variation in capital structures even among otherwise-similar companies.

Practical considerations affecting capital structure include the following:

• Industry norms
• Company size
• Company life cycle
• Growth prospects
• Tax environment
• Regulatory environment
• Market conditions
• Management philosophy

Capital structure is important to businesses of all kinds, from small businesses managing their start-up finances to large international companies managing their funds with an eye on expansion. Each business should make sure that theyre using the optimal capital structure for their business and industry. The balance sheet shows how much of a company is financed by creditors and owners, and also provides insights into the company’s cost of capital.

In summary, capital structure is the mix of debt and equity used by a company to finance its operations and growth. The optimal capital structure is the proportion of debt and equity that results in the lowest weighted average cost of capital for the firm. Practical considerations affect capital structure, and each business should make sure that theyre using the optimal capital structure for their business and industry.