Definition of Capital Structure

Capital structure is the structure of two main sources of finance (Debt & Equity) that a company maintains on its books. A capital structure is made up partially from debt and partially from equity.

A capital structure that is mostly financed with debt is considered riskier as it bears the great risk of default and there is a high amount of interest has to be paid out of profits before distribution to ordinary shareholders. Due to this reason, the ordinary shareholders require a higher rate of return from the company for compensation against the high default risk they are bearing.

Two ratios measure capital structure:

Debt/Equity ratio = Total Debt / Total Equity

Debt/Total Assets = Total Debt / Total assets