Capital structure describes the amount of debt a company uses as opposed to equity, and it is often measured with the ratio of debt to equity. The more debt a company has, the more it has to pay creditors for the use of those funds. However, the more debt a company takes on, the more cash it has to generate sales. The challenge is in finding the right equilibrium between debt and equity for an optimal capital structure, which can then be leveraged to grow the business.

Amplifies Return-on-Equity

Return on equity, or ROE, is commonly used as a measure of business performance. It is the product of earnings, asset turnover and financial leverage or debt. The more leverage or debt you have in your capital structure, the more it amplifies your potential earnings. At the same time, an increase in debt or leverage also reduces earnings since interest is paid out of net earnings.

Greater Control and Flexibility

Debt financing allows you to keep full ownership over your business. With full ownership comes complete control. Equity financing is an investment in the ownership rights of the company. That is, equity investors get a portion of earnings. If there are no earnings, equity investors aren't paid. However, debt investors must be paid no matter what happens. Failure to pay interest can result in a default, which results in a credit event. In this way, capital structure helps to better control and manage operational flexibility.

Framework for Negotiation

Capital structure provides an organized way to raise capital. Both debt and equity have their advantages and disadvantages. The equity investor gets a portion of your earnings no matter how much earnings grow, and the amount earned by equity investors is not limited by a certain period of time like debt. Once the loan is paid off, the creditor has no right to your earnings. Debt financing is also easier to negotiate and handle administratively than equity, which can come with complex reporting requirements.

Equity Advantages

Capital structure also provides flexibility in raising funds. One advantage to equity financing for small business is that it is generally more available than debt financing. If your business is unproven, lenders have nothing to base future cash flows on. This may result in a requirement for a personal guarantee from one of the business owners. Equity financing is not required to be paid back immediately.