What are the most common mistakes companies make with their capital structure?

1 Mistake 1: Overleveraging

One of the most common mistakes companies make with their capital structure is overleveraging, which means taking on too much debt relative to their equity and cash flow. While debt can be a useful tool to leverage returns and take advantage of tax benefits, it also increases the financial risk and the burden of interest payments. If a company overleverages, it may face difficulties in meeting its debt obligations, especially in times of economic downturn or market volatility. It may also lose flexibility and bargaining power with its creditors and stakeholders. To avoid overleveraging, a company should carefully assess its debt capacity, its debt maturity profile, and its debt covenants, and maintain a prudent level of liquidity and solvency.

2 Mistake 2: Underleveraging

Another common mistake companies make with their capital structure is underleveraging, which means relying too much on equity and not enough on debt. While equity can be a source of stability and growth, it also comes at a cost. Equity investors expect a higher return than debt holders, and they have a residual claim on the firm's assets and earnings. If a company underleverages, it may miss out on the benefits of debt, such as lower cost of capital, tax shields, and discipline. It may also signal a lack of confidence or opportunities to the market, and dilute the ownership and control of the existing shareholders. To avoid underleveraging, a company should consider its optimal capital structure, its growth prospects, and its dividend policy, and use debt strategically to enhance its value and competitiveness.

3 Mistake 3: Ignoring the market conditions

A third common mistake companies make with their capital structure is ignoring the market conditions and the expectations of the investors and analysts. The market conditions can affect the availability, cost, and terms of debt and equity financing, and the valuation of the firm. The investors and analysts can influence the perception, reputation, and rating of the firm, and the demand and price of its securities. If a company ignores the market conditions, it may fail to take advantage of favorable opportunities to raise or retire capital, or to adjust its capital structure to changing circumstances. It may also face a mismatch between its actual and target capital structure, and a divergence between its intrinsic and market value. To avoid ignoring the market conditions, a company should monitor the trends and signals of the market, communicate effectively with its investors and analysts, and align its capital structure decisions with its strategic goals and market expectations.

4 Mistake 4: Following the herd

A fourth common mistake companies make with their capital structure is following the herd, which means copying or mimicking the capital structure choices of other companies in their industry or peer group. While benchmarking can be a useful tool to compare and evaluate the performance and practices of different firms, it can also lead to suboptimal or irrational decisions. If a company follows the herd, it may overlook its own unique characteristics, such as its business model, risk profile, growth potential, and competitive advantage. It may also fall into the trap of conformity, complacency, or contagion, and lose its differentiation and innovation. To avoid following the herd, a company should adopt a critical and independent approach to its capital structure decisions, and base them on its own analysis, objectives, and capabilities.

5 Mistake 5: Being inflexible

A fifth common mistake companies make with their capital structure is being inflexible, which means sticking to a rigid or fixed capital structure policy regardless of the changing internal and external factors. While consistency and stability can be desirable qualities for a capital structure policy, they can also be detrimental if they prevent a company from adapting and responding to new challenges and opportunities. If a company is inflexible, it may miss out on the benefits of dynamic capital structure adjustment, such as minimizing the cost of capital, maximizing the value of the firm, and exploiting the market timing effects. It may also expose itself to unnecessary risks or inefficiencies, and lose its competitive edge and sustainability. To avoid being inflexible, a company should adopt a flexible and responsive capital structure policy, and review and revise it periodically based on its performance, environment, and strategy.

6 Here’s what else to consider

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