Financial Structure
The term "financial structure" refers to the specific mixture of long–term debt and equity that a company uses to finance its operations. Why it matters? The composition directly affects the risk and value of the associated business.
First, a little about the choices. Equity represents ownership in the company, usually in the form of stock. Debt represents loans.
A company doesn't have to pay back stock. There's no cost, per se. The shareholders make money when the price of the asset (the company) rises in value.
Debt has to get paid back. Also, there's a cost to having debt, in the form of interest. The company has to write regular checks to repay the debt (think about your monthly mortgage payment and you'll get the idea).
But bringing in debt doesn't dilute your ownership. The more shares sold to outsiders, the less of the company the original founders own. Sell enough equity and the company's founders no longer have much say over "their" company.
So debt and equity both have pluses and minuses. A financial structure with too much debt gets expensive. Take on too many loans, and the regular payments of interest and principal cut deeply into operating profit. The company can't afford to do much other than service the debt.
Meanwhile, weight your financial structure too far toward equity and you can cease to own "your" company.
You found a company, holding 100% of the equity. You sell half to fund expansion. Now you own 50%. You don't care too much because you're still the largest single shareholder, plus you used the money you made selling stock to expand your business. The 50% of the your new, expanded company is worth much more than the 100% of the small startup you had before.
You want another round of expansion, so you sell half your stock again. Now you own 25%. Try the process again...12.5%.
You keep going until the company itself is very big, but you own a vanishing part of it. Eventually, you get in a tiff with some members of your board and you're asked to leave (See: Steve Jobs, circa 1985).
Why take any of these risks? Because companies need money for expansion, to build factories or hire sales people. Taking on debt or selling equity allows small garage startups to become multi-billion dollar global behemoths.
But balancing the financial structure is a key concern of corporate managers. They want to keep the cost of capital down, while making sure that their shareholders don't revolt due to excessive dilution.
Related or Semi-related Video
Finance: What is off balance sheet finan...4 Views
finance a la shmoop what is off-balance-sheet financing well it's
like money from a fourth dimension money is being borrowed stuff is being bought [money floating in the universe]
but somehow on the normally filed books and numbers of 10-qs and k's and other [stack of paper on table]
filings well it's like that song she's not there companies want to show as
little debt as possible on their books for a variety of reasons like go well
they don't want to look vulnerable to their competitors if a big luscious
jewel comes along that they can buy and they have too much debt already on their [gigantic diamond]
books they also want to pay the cheapest rent on their debt possible and less
debt means less risk in paying back the dough so that makes companies look less
leveraged and more able to take on more debt and well make shareholders happier [clipboard]
so when companies need things they will actively look to find financially
efficient ways of buying them and a lot of times that involves off-balance-sheet
financing our friendly tractor smelting company needs a new factory it can buy
one for a hundred million dollars huge debt on its books if it borrowed all [factory for sale]
hundred million risk all kinds of other liabilities as well well if the company
was sitting on a fat stack of a billion dollars than was you know burning a hole [businessman sitting on a pile of money]
in its pocket well then this might be a viable thing to do and they just write a
check but that last Union strike cost him a fortune in the company and its [union workers on strike]
creditors are worried there might be another strike which would fully
bankrupt the company and put everyone out of a job and make the debt loaned to
the company to buy that factory while fully bust so what can the company do [balloon of debt pops]
instead well they need this Factory the old one is slowly but surely slipping
into the muck surrounding the neighboring a nuclear plant there yes [factory sinking into green goo]
sorry well one type of off-balance-sheet financing comes from leasing that is the
company could take on an operating lease on an already existing tractor smelting
Factory that has just been sitting there ten miles down the road a victim of the
last Union strike from a competitor which actually did bankrupt that company
so the smelting Factory is great in new and it's just waiting to be leased and
the banks that now own it would be only too delighted to get at least some cash
flow coming back to them and lease it to the tractor smelting company here yeah [leasing agreement changes hands]
that one so from an accounting perspective there
isn't debt that appears on the balance sheet when they form an operating lease
to take over that Factory in essence the lease is just rent and appears as normal
vanilla expense it's off balance sheet it is essentially financing an operating
asset without triggering debt covenants that make that long-term commitment to
leasing the factory look like it is in fact legally dead or it's not existing
think about the way in which accounting is handled for a five-year lease on a
building that leased covers 60 months said they'll say ten grand a month or
six hundred thousand dollars worth of financial commitment or obligation paid
monthly well legally the company is inextricably bound to paying its rent
for the entire duration of the lease is that money considered debt well in this
case no but it's not far from being treated as an off-balance sheet event
and in practice conservative companies actually put a line for lease
obligations as one of their most current and long-term sets of liabilities and
you can imagine them getting out of that with one little trick in there that well
should the company give 30 days notice they'd be out of obligation for the
least in which case well they wouldn't have to report it as a long-term kind of
lease liability and that would help it be off balance sheet they wouldn't
really have to note it in that sense all right Alex Enron for a thousand so yes
if you don't remember because you were still in the womb doing backstroke Enron [pictures of baby in womb]
was one of the great off-balance sheet fraudulent chicanery exercises in [Enron logo]
American business history the company deployed some of the most evilly clever
accounting practices in history to hide the fact that it in fact owed massive [zombie]
debt obligations which were buried as being quote off-balance sheet assets
unquote well how did they pull off this magic
well the shell game revolved largely around sometimes real and often faked
partnerships where Enron would choose at will to be viewed either as a majority
or a minority participant in a transaction than had a loan or debt
attached to it such that with smoke and mirrors it could make it appear as if it
owned the debt liability and more often than not the debt liability was in fact
owned by its shield partners so it kind of went away as a debt obligation
phantom the precept did not reporting the real numbers came from the ability
to call the debt liabilities off balance sheet the perception was that the
company had an asset that was growing quickly but in fact the company was
borrowing a dollar to buy 50 Cent's of notional revenue the bottom line
off-balance sheet transactions are only so far off in the long arm of law and
the collection agency comes with the baseball bats reach into all kinds of
nooks and crannies around the globe and yeah here's what happened to the guy
orchestrating the whole Enron dance
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