Renovating a house can make it more attractive and more valuable without changing the ground it stands on. Capital restructuring does something similar to a company: it changes the mix of debt and equity funding the business, without necessarily changing the business itself. Done well it lowers the cost of funding and improves returns. Done badly it is how solid companies fail.
What the Capital Structure Is
Every business is funded by some combination of two things:
- Equity — money from owners, plus profits retained rather than distributed. It has no repayment date and no required payment, which makes it safe. It is also the most expensive form of funding, because owners expect a higher return for taking the most risk.
- Debt — borrowing that must be serviced and repaid on a schedule regardless of how trading is going. Cheaper than equity, partly because lenders take less risk and partly because interest is generally tax-deductible.
The mix is the capital structure, and restructuring means deliberately changing it — borrowing to buy back shares, issuing shares to repay debt, refinancing existing borrowing, or converting one into the other.
Why Companies Do It
- Lower the overall cost of capital by using more of the cheaper source, within the limits of safety.
- Improve earnings per share. Borrowing to buy back shares spreads the same profit over fewer shares. Note that this raises EPS without the business earning a cent more, which is why the measure should never be read alone.
- Refinance at a better rate or a longer maturity, or to remove restrictive conditions.
- Fund growth or an acquisition.
- Relieve distress — converting debt to equity when the schedule cannot be met, which dilutes owners but may save the company.
- Change who controls the business, which is what a leveraged buyout does.
Leverage Cuts Both Ways
This is the whole subject in one idea. Debt magnifies returns to owners when things go well and magnifies losses when they do not, because the interest is owed either way.
Consider a business earning $100,000 a year on $1,000,000 of assets. Funded entirely by equity, the owners earn 10%. Funded with $500,000 of equity and $500,000 of debt at 6% — $30,000 of interest — the owners earn $70,000 on $500,000, or 14%. Leverage improved the return by four points.
Now let earnings fall to $30,000 in a bad year. The all-equity business earns 3% and is uncomfortable. The leveraged business owes exactly its entire earnings in interest, returns nothing to owners, and one further step down means it cannot pay. Same business, same downturn, entirely different outcome.
How Much Debt Is Sensible
There is no universal ratio, but the factors that decide it are consistent:
- How stable and predictable the cash flow is. A utility can carry debt that would destroy a seasonal business.
- Whether there are assets a lender can secure against, which is why property-heavy businesses borrow more cheaply than service businesses.
- How much headroom the business needs for opportunity or a downturn.
- What the covenants require. Loan conditions can force action at exactly the worst moment, and breaching one is often more dangerous than missing a payment.
- What is normal in the industry, which reflects accumulated experience about what that sector can carry.
The Same Question in a Small Business
Owners face this decision without calling it capital structure: borrow for the equipment, or fund it from profits? Take an investor, or keep full ownership and grow more slowly?
The trade is identical. Debt keeps your ownership and adds a fixed obligation that does not care about a slow quarter. Equity brings money and often expertise, costs no fixed payment, and permanently gives away a share of everything the business ever earns — plus, usually, some say in how it is run.
Two cautions specific to small business: most lending to small companies requires a personal guarantee, which means the debt is not really the company’s alone; and borrowing to cover ongoing losses rather than to fund an asset that will earn is how a survivable problem becomes an unsurvivable one. See small business loans and SBA financing.
