Capital structure refers to the specific mix 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 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.

Factors that affect capital structure include business characteristics, such as a companys business model, operations, or maturity, and practical considerations, such as the market values of debt and equity. When determining their capital structure, owners and managers of firms have to consider many tradeoffs, such as the level of risk they are willing to take on and the cost of capital.

A sound capital structure is important for a firm as it determines the overall stability of the firm. Here are some of the other factors that highlight the importance of capital structure:

• A firm having a sound capital structure has a higher chance of increasing the market price of the shares and securities that it possesses. It will lead to a higher valuation in the market.
• A good capital structure ensures that the available funds are used effectively. It prevents over or under capitalisation.
• It helps the company in increasing its profits in the form of higher returns to stakeholders.
• A proper capital structure helps in maximising shareholder’s capital while minimising the overall cost of the capital.
• A good capital structure provides firms with the flexibility of increasing or decreasing their debt or equity levels as per the market conditions.