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What Is the Connection between Leverage and Capital Structure?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 05 September 2016
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Leverage and capital structure are two items that link to a company’s operations, with financial figures related to the items on the company’s balance sheet. Leverage represents monies paid for fixed assets, which are items that cost a great deal of money but are necessary to produce goods and services. Common types of funds for fixed assets often include bonds issued by the company and debt from bank loans. The connection between leverage and capital structure is that companies use a mix of debt and equity finance for operations, with stakeholders interested in how a company manages its business. In some cases, companies with too much leverage indicate a risky company that may not offer good financial returns.

There are few different types of leverage that exist outside of a company’s balance sheet, namely operating and financial leverage. These items also have a connection to a company’s balance sheet as the items provide capital for repaying bonds or debt. Operating leverage is basically sales revenue less cost of goods sold and less operating expenses, with the result being earnings before interest and taxes (EBIT). Financial leverage is EBIT less interest expenses, taxes, and preferred stock dividends, which result in earnings available for common shares, or earnings per share. The income statement forms of leverage and capital structure as listed on the balance sheet are all important in business.

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Business analysts or capital finance departments are typically the source of a company’s defined capital structure. In most cases, a company has a set capital structure for all business operations and possibly different structures for each department or project. Again, there is most likely a mix of debt and equity funds that make up this structure. There is no single answer on how a company should create this mix. In most cases, a company’s leverage and capital structure comes down to the cost paid for the funds, the type of project that needs financing, and the long-term results of the financing types.

In capital structure, a company most likely prefers to avoid the use of bonds and other debt. These funds usually offer more rights to the other parties vested in the loans made for the leverage and capital structure. This increases the risk for each project as debt repayments must be made, or a company may face significant penalties that can reduce financial returns. Equity funds — most often stock — do not have the same guarantees as debt, making these funds more attractive. Small companies, however, may not have the ability to issue stock, leaving their leverage and capital structure one sided.

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