capitalization

(kăp'ĭ-tl-ĭ-zā'shən)
n.

1. 1. The practice or act of capitalizing.
   2. The sum that results from capitalizing.
2. 1. The amounts and types of long-term financing used by a firm, including common stock, preferred stock, retained earnings, and long-term debt.
   2. The total par value or stated value of no-par capital stock issues.
3. The use of capital letters in writing or printing.

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corporation’s financial framework, including long-term debt, preferred stock, and net worth. It is distinguished from financial structure, which includes additional sources of capital such as short-term debt, accounts payable, and other liabilities. It is synonymous with capitalization, although there is some disagreement as to whether capitalization should include long-term loans and mortgages. Analysts look at capital structure in terms of its overall adequacy and its composition as well as in terms of the debtto- equity ratio, called leverage. See also capitalization ratio; par value.

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Capital structure is a business finance term that describes the proportion of a company's capital, or operating money, that is obtained through debt and equity. Debt includes loans and other types of credit that must be repaid in the future, usually with interest. Equity involves selling a partial interest in the company to investors, usually in the form of stock. In contrast to debt financing, equity financing does not involve a direct obligation to repay the funds. Instead, equity investors become part-owners and partners in the business, and thus are able to exercise some degree of control over how it is run.

Since capital is expensive for small businesses, it is particularly important for small business owners to determine a target capital structure for their firms. Capital structure decisions are complex ones that involve weighing a variety of factors. In general, companies that tend to have stable sales levels, assets that make good collateral for loans, and a high growth rate can use debt more heavily than other companies. On the other hand, companies that have conservative management, high profitability, or poor credit ratings may wish to rely on equity capital instead.

Advantages and Disadvantages of Financing Options

Both debt and equity financing offer small businesses a number of advantages and disadvantages. The key for small business owners is to evaluate their company's particular situation and determine its optimal capital structure. As Eugene F. Brigham explained in Fundamentals of Financial Management, "The optimal capital structure is the one that strikes a balance between risk and return and thereby maximizes the price of the stock and simultaneously minimizes the cost of capital."

The primary advantage of debt financing is that it allows the founders to retain ownership and control of the company. In contrast to equity financing, the entrepreneurs are able to make key strategic decisions and also to keep and reinvest more company profits. Another advantage of debt financing is that it provides small business owners with a greater degree of financial freedom than equity financing. Debt obligations are limited to the loan repayment period, after which the lender has no further claim on the business, whereas equity investors' claim does not end until their stock is sold. Debt financing is also easy to administer, as it generally lacks the complex reporting requirements that accompany some forms of equity financing. Finally, debt financing tends to be less expensive for small businesses over the long term, though more expensive over the short term, than equity financing.

The main disadvantage of debt financing is that it requires a small business to make regular monthly payments of principal and interest. Very young companies often experience shortages in cash flow that may make such regular payments difficult, and most lenders provide severe penalties for late or missed payments. Another disadvantage associated with debt financing is that its availability is often limited to established businesses. Since lenders primarily seek security for their funds, it can be difficult for unproven businesses to obtain loans.

The main advantage of equity financing for small businesses, which are likely to struggle with cash flow initially, is that there is no obligation to repay the money. Equity financing is also more likely to be available to concept and early stage businesses than debt financing. Equity investors primarily seek growth opportunities, so they are often willing to take a chance on a good idea. But debt financiers primarily seek security, so they usually require the business to have some sort of track record before they will consider making a loan. Another advantage of equity financing is that investors often prove to be good sources of advice and contacts for small business owners.

The main disadvantage of equity financing is that the founders must give up some control of the business. If investors have different ideas about the company's strategic direction or day-to-day operations, they can pose problems for the entrepreneur. In addition, some sales of equity, such as initial public offerings, can be very complex and expensive to administer. Such equity financing may require complicated legal filings and a great deal of paperwork to comply with various regulations. For many small businesses, therefore, equity financing may necessitate enlisting the help of attorneys and accountants.

Further Reading:

Brealey, Richard A., and Stewart C. Myers. Principles of Corporate Finance. 4th ed. McGraw-Hill, 1991.

Brigham, Eugene F. Fundamentals of Financial Management. 5th ed. Dryden Press, 1989.

Hamilton, Brian. Financing for the Small Business. U.S. Small Business Administration, 1990.

Kochhar, Rahul, and Michael A. Hitt. "Linking Corporate Strategy to Capital Structure." Strategic Management Journal. June 1998.

Lindsey, Jennifer. The Entrepreneur's Guide to Capital. Probus, 1986.

Mishra, Chandra S., and Daniel L. McConaughy. "Founding Family Control and Capital Structure." Entrepreneurship: Theory and Practice. Summer 1999.

Romano, Claudio A., et al. "Capital Structure Decision Making: A Model for Family Business." Journal of Business Venturing. May 2001.

See also: Debt Financing; Equity Financing

noun

Money or property used to produce more wealth: backing, capital, financing, funding, grubstake, stake, subsidization. See help/harm/harmless, money.

1. for accounting purposes, the allocation of an item of expense to the capital account because of the relatively long life of the asset acquired by the expense. 2.
“[A] method of computation which gives value to land in relation to the income it produces.” 363 N.E. 2d 1018, 1021. 3. The total of long-term capital , such as long-term loans and notes, bonds, mortgages, and stock, used by a business to purchase assets.

A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. 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.

Investopedia Says:
A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered.

Related Links:
Learn about debt ratios and how to use them to assess a company's financial health. You could save a lot of money! Debt Reckoning
Borrowed funds can mean a leg up for companies, or the boot for investors. Find out how to tell the difference. Will Corporate Debt Drag Your Stock Down?
Learn what it means to do your homework on a company's performance and reporting practices before investing. Advanced Financial Statement Analysis
Find out how analysts determine the fair value of a company with this step-by-step tutorial and learn how to evaluate an investment's attractiveness for yourself. Discounted Cash Flow Analysis
Learn to use the composition of debt and equity to evaluate balance sheet strength. Evaluating A Company's Capital Structure

For a list of words related to capitalization, see:

• Corporations and Business Practices - capitalization: total funds of corporation, including stocks, bonds, undivided profits, and surplus
• Income Tax - capitalization: transferring cost of certain assets to balance sheet rather than taking full expense in year of purchase

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