The composition of a company's capital in terms of equity (common and preferred stock), debt (including bonds and loans) and hybrid securities (such as convertible debt and preferred shares).
Equity financing is provided by the shareholders. Debt financing is provided by banks or bondholders who, respectively, receive loan contracts and publicly traded bonds in return for their money.
The capital structure shows the composition of a group’s liabilities as it shows who has a claim on the group's assets and whether it is a debt or equity claim. The leverage ratio is the proportion of the group’s liabilities that is financed by debt claims.
The capital structure of corporations can be quite complex as there are many different types of debt and equity claims. For example, debt claims vary according to their maturity (short term or long term), seniority (senior or junior), the type of covenants associated with the debt, whether the debt is secured or unsecured, and whether the debt is privately held or publicly traded.
The optimal debt-equity mix is explained by a number of capital structure theories. According to these theories there are costs and benefits associated with debt as well as equity. The company should choose the combination of debt and equity that maximises its value.
According to the trade-off theory of capital structure, companies optimally trade off the tax shield advantage of debt against the expected bankruptcy costs. The interest repayments on debt are tax deductible. This benefit of debt has to be traded off against the increase in expected bankruptcy costs that result from taking on higher debt levels. Highly levered companies are more likely to go bankrupt, and value gets destroyed in bankruptcy, especially if the assets lose a large fraction of their value in bankruptcy.
Other theories, such as the pecking order theory of capital structure, invoke the information asymmetry between inside shareholders and outside shareholders. Given that insiders are more likely to issue new shares when shares are overvalued, a company's announcement to issue more shares may lead to a drop in share price. To avoid this adverse selection cost, companies might in the first instance rely on internal financing or debt financing, and only issue new shares as a last resort. This results in a 'pecking order' of financing.
Industries in which companies have highly tangible assets that preserve their value in liquidation tend to have high leverage ratios, and vice versa. For example, internet companies, knowledge-based companies and human capital intensive companies all tend to rely primarily on equity financing because their assets are intangible and not suitable as collateral for debt financing.