Financing Structure

Financing Structure

On the debt financing side, the banker uses LBO analysis to help craft a viable financing structure for the target, which encompasses the amount and type of debt as well as an equity contribution from a financial sponsor. the model output enables the banker to analyze a given financing structure on the basis of cash flow generation, debt repayment, credit statistics, and investment returns over a projection period .

The analysis of an LBO financing structure is typically spearheaded by an investment banks  leveraged finance and capital market teams (along with a sector coverage team, collectively the "deal team"). The goal is to present a financial sponsor with tailored financing options that maximize returns while remaining marketable to investors. The financing structure must also provide the target with sufficient flexibility and cushion to run it's  business according to plan

Financial Structure Versus Capital Structure

While a capital structure and a financial structure both include information regarding long-term financing and common stock, preferred stock and retained earnings, it does not include any information regarding short-term debt obligations. A financial structure does include both long-term and short-term obligations in its calculation. In this regard, the capital structure can be seen as a subset of the financial structure that is more geared toward long-term analysis, while the financial structure provides more reliable information regarding the business's current circumstances.

Differences in Financial Structures

The design of a business's financial structure may vary from country to country and may shift in response to changes within its country’s economy. Often, these differences are attributed to the relevance of the banking system for overall business operations.

Certain production facilities may be more inclined to rely on traditional bank loan offerings, as well as those that have the option to back financing with collateral, such as construction and agriculture. Further, a smaller business may be more likely to consider traditional financing models, as the availability of private investments or the ability to issue securities may not be available.

Businesses in sectors that are more reliant on human capital may be more inclined to finance operations by issuing bonds or other securities. This may allow them to obtain a more favorable rate, since the option to collateralize assets may be highly limited. Larger firms, regardless of their industry, may be more inclined to consider offering bonds or other securities, especially if the businesses already have shares traded on a public exchange.

Capital Structure

The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure.

Debt vs. Equity

Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to issue debt because of the tax advantages. Interest payments are tax-deductible. Debt also allows a company or business to retain ownership, unlike equity. Additionally, in times of low interest rates, debt is abundant and easy to access.

Equity is more expensive than debt, especially when interest rates are low. However, unlike debt, equity does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part owner.

Debt-to-Equity Ratio as a Measure of Capital Structure

Both debt and equity can be found on the balance sheet. The assets listed on the balance sheet are purchased with this debt and equity. Companies that use more debt than equity to finance assets have a high leverage ratio and an aggressive capital structure. A company that pays for assets with more equity than debt has a low leverage ratio and a conservative capital structure. That said, a high leverage ratio and/or an aggressive capital structure can also lead to higher growth rates, whereas a conservative capital structure can lead to lower growth rates. It is the goal of company management to find the optimal mix of debt and equity, also referred to as the optimal capital structure.

Analysts use the D/E ratio to compare capital structure. It is calculated by dividing debt by equity. Savvy companies have learned to incorporate both debt and equity into their corporate strategies. At times, however, companies may rely too heavily on external funding, and debt in particular. Investors can monitor a firm's capital structure by tracking the D/E ratio and comparing it against the company's peers.