How does a company's capitalization structure affect its profitability?

The capitalization structure of a business is its foundation. From its first sale to the projects it invests in down the road, everything begins with the way it finances its operations. The capitalization structure can have a huge impact on a company's profitability.

Capitalization structure (more commonly called capital structure) simply refers to the money a company uses to fund operations and where that money comes from. Capital can be raised either through the acquisition of debt or through equity. Equity financing comes from the sale of stock to shareholders. Debt can come from many sources, such as bank loans, personal loans and credit card debt, but it must always be repaid at a later date, usually with interest.

Both types of capital financing carry some degree of expense that must be paid to access funds, called the cost of capital. For debt capital, this is the interest rate charged by the lender. The cost of equity is represented by the rate of return on investment that shareholders expect in dividends. While debt tends to cost less than equity, both types of capital financing impact a company's profit margins in important ways.

Perhaps the clearest example of this is the impact of debt on the bottom line. Somewhere between operational expenses and the net profit figure on a company's income statement lies expenses incurred for the payment of debts. A company with a particularly debt-heavy capital structure makes larger interest payments each year, thereby reducing net profit.

Debt capital can also have a positive effect on profitability. Debt allows companies to leverage existing funds, thereby enabling more rapid expansion than would otherwise be possible. The effective use of debt financing results in an increase in revenue that exceeds the expense of interest payments. In addition, interest payments are tax-deductible, reducing a company's overall tax burden.

The impact of equity financing on a company's profit margins is equally important, though not quite so straightforward. While equity funds stimulate growth without requiring repayment, shareholders are granted limited ownership rights, including voting rights. They also expect a return on their investment in the form of dividends, which are only paid if the company turns a profit. A business funded by shareholder equity is beholden to its investors and must remain consistently profitable in order to fulfill this obligation.

Business ownership is shared, so the proverbial pie of profits must be divided into a greater number of pieces. A company funded fully by debt may have hefty interest payments each month, but when all is said and done, the profits belong entirely to the business owners. Without shareholder dividends to pay, the profits can be reinvested in the business through the purchase of new equipment or by opening a new location, generating even greater profits down the road.

Another indirect effect of capital structure on profitability is its impact on the potential availability of additional capital if it is needed in the future. A company with a particularly high debt to equity ratio may be seen as unnecessarily risky by both lenders and potential shareholders, making it difficult to raise additional funds. Limited access to capital funding, in turn, limits the business's growth potential, keeping profit margins stagnant.

(For related reading, see "What Is Capital Structure Theory?")