A 3-Step Capital Structure Health Check You Can Run This Week

🛠 THE CFO EFFECT PLAYBOOK (Part II)

Step 1 – Understand the True Cost of Equity

Most leaders underestimate how expensive equity really is.
They look at it as “free money”: no repayment schedule, and no interest expense.
But equity is the costliest form of capital you’ll ever raise.

Here’s why:

1️ - Shareholders Take the Highest Risk

• Debt holders get repaid first (interest + principal).

• Equity holders get paid last, after everyone else.

• In a liquidation, lenders recover collateral, but shareholders can lose everything.

Because of this risk profile, equity investors demand a premium return that compensates them for potentially losing 100% of their capital.

2️ - The Unlimited Upside Comes at a Price

Equity investors accept the risk of total loss because they also get the benefit of unlimited upside.

• If the business 10x’s, they capture that exponential growth.

• But for the company, this means you’ve effectively “sold” a portion of your future value creation.

That’s not free, it’s a long-term, compounding cost.

3️ - Why Banks Don’t Take Equity Risk

No lender will agree to carry equity-level risk for debt-level returns.

Story from my banking days:
A colleague pitched me a financing deal for a large shipping company.

On paper, it was structured as “debt.”

But after reviewing the financials, here’s what I saw:

• Losses, year after year.

• A cyclical industry highly dependent on global trade.

• Weak prospects ahead.

If I had financed that with debt, I wouldn’t be lending.
I’d be taking equity risk without equity reward.
That’s a deal no smart banker should ever touch.

Lesson: If your business burns equity faster than it rebuilds it, don’t expect lenders to step in.

Debt providers aren’t venture capitalists.

4️ - Equity as the Shock Absorber of Your Business

Think of equity as the suspension system in your car:

• It cushions shocks.

• It protects the rest of the vehicle (debt holders).

• Without enough suspension, every bump becomes catastrophic.

When your equity cushion shrinks:

• Lenders get nervous. They feel like they’re holding equity risk at debt returns.

• They respond by tightening terms or raising rates.

• Your Weighted Average Cost of Capital (WACC) rises, making growth more expensive.

That’s when the financing system breaks down.

5️ - When Equity Is Useful (and When It’s Not)

Equity isn’t inherently bad. It’s essential in certain situations:

• Startups / high-risk ventures where debt isn’t available.

• Early-stage expansion before cash flows are predictable.

• Bridge financing to strengthen the balance sheet and restore lender confidence.

But once you have stable, recurring cash flows, relying too much on equity is wasteful.

At that stage, debt becomes a cheaper, more efficient tool. As long as you maintain a healthy equity buffer.

CFO Playbook – Managing Equity Intelligently

• Use equity strategically to absorb risk in early or volatile stages.

• Protect equity cushion, avoid year-over-year erosion that shifts risk to lenders.

• Balance equity and debt, don’t swing too conservative (lazy balance sheet) or too aggressive (fragile structure).

• Always compare the cost of equity vs. cost of debt. Remember, equity is invisible on your P&L, but it’s still the most expensive capital you’ll ever use.

✅ Takeaway: Equity isn’t “free.” It’s your most expensive capital.

Use it wisely, protect it aggressively, and remember: if your equity base shrinks, you’re effectively asking lenders to take equity-level risk for debt-level reward.

That’s when capital costs spike, relationships strain, and growth stalls.

Step 2 – Check Your Equity-to-Debt Balance

If Step 1 is about understanding that equity is your most expensive capital, Step 2 is about making sure you’ve got the right balance between equity and debt.

Too little equity and your business becomes fragile.
Too much equity and your business becomes lazy.

The sweet spot is somewhere in between.

And finding it is one of your most important jobs as CFO.

1️ - What a Healthy Balance Looks Like

• ~25% equity / 75% debt-liabilities mix
  → Most lenders view this as a comfortable balance.

It shows the owners have “skin in the game” but also leverage debt effectively.

• 15–20% equity
  → This can still be fine, but only if your cash flows are strong, sustainable, and predictable.

SaaS with recurring revenue could do. But seasonal retail with volatility, probably not.

• <15% equity
  → Red flag territory. This is where lenders start to see equity risk disguised as debt.

They know if things go south, they’re absorbing risk without the return profile of equity.

That’s when spreads widen, covenants tighten, and capital costs spike.

2️ - What Happens When Equity Shrinks Too Far

Case in point: Restoration Hardware (RH).

• At ~14% equity, RH was already running lean.

• Losses pushed them into negative equity territory.

• With every quarter of losses, equity evaporated further.

What happened next?

• Lenders demanded higher returns for higher risk → interest costs increased.

• Rising interest expense further squeezed profits → weaker cash flows.

• Weak cash flows made lenders even more cautious → risk perception spiked again.

That’s the vicious cycle of poor capital structure. Once it starts, it feeds on itself.

 3️ - The Other Extreme (Too Much Equity)

But being over-capitalized is no prize either.

I’ve seen clients who keep way too much equity in their businesses resulting in:

• Bloated balance sheets: the company is overfunded relative to its risk profile.

• Cash stranded in low-yield GICs or sitting idle instead of being reinvested.

• Suppressed returns on equity (ROE) because excess capital drags down overall profitability metrics.

In plain English: they were sitting on a “lazy balance sheet.”

Instead of putting capital to work (acquisitions, innovation, or even distributing it back to owners) they parked it in low-return assets.

It felt safe, but safety came at the cost of performance.

4️ - The CFO Lens: Striking the Right Balance

Your job as CFO is to manage this balance dynamically, not statically.

The right mix evolves as your company grows:

• Early-stage / volatile cash flows → More equity cushion. Lenders want comfort.

• Growth-stage / predictable revenues → Add debt to scale while keeping equity efficient.

• Mature / stable businesses → Optimize for returns by not overfunding with idle equity.

The art is in knowing when to add leverage to drive growth and when to strengthen equity to weather storms.

Step 3 – Run the Health Check

Here’s where the theory turns practical.
You don’t need a 50-page consultant deck to know whether your capital structure is healthy.

You need a repeatable framework (one you can run in less than an hour) to pressure-test your balance sheet.

Here’s the CFO-level 3-step checkup you can run this week:

1️ - Pull the Numbers (Your Vital Signs)

Start with the basics:

• Equity Ratio – Equity ÷ Total Assets. Are shareholders carrying their share of the load?

• Debt-to-Equity Ratio – Total Debt ÷ Equity. Is debt proportionate to your equity cushion?

• Debt-to-EBITDA – How many years of EBITDA would it take to pay off your debt?

• Interest Coverage Ratio – EBIT ÷ Interest Expense. Do you have enough operating profit to service your debt comfortably?

Think of these as your “blood pressure, cholesterol, and heart rate”.

If they’re out of range, it’s a warning sign.

2️ - Benchmark (Compare Yourself to the Right Standards)

A single number in isolation means nothing. Context is everything.

• Industry Peers: Retail can’t carry the same leverage as SaaS. Utilities can run with more debt than DTC brands.

• Your 3–5 Year Trend: Are your ratios improving with profitability or deteriorating with losses?

• Investor Expectations: How do your ratios stack up against what equity analysts and lenders consider “healthy” in your sector?

The real question isn’t “Is 3.5x Debt/EBITDA bad?” It’s:

• Is that level normal for my industry?

• Is it improving or worsening over time?

• Does it align with my strategy?

3️ - Stress-Test (Simulate the Storm Before It Hits)

A good CFO never assumes smooth sailing.

You model what happens when the tide turns.

• Drop EBITDA by 20% which is a realistic downside for most businesses.

• Recalculate Debt-to-EBITDA and Interest Coverage.

• Watch what happens to your equity ratio.

If a modest 20% dip pushes you into covenant breach territory, you’re operating with a brittle structure.

 And markets always punish brittle companies first.

Reminder: Restoration Hardware didn’t fall because the brand was weak. It fell because the capital structure couldn’t absorb a downturn.

The CFO Lens – Why This Matters

Capital structure is not static.

It moves with every profit, loss, rate hike, or growth bet you make.

A strong equity base does four things for you:

• Lowers risk perception (lenders and investors see you as safe).

• Reduces cost of capital (both debt and equity become cheaper).

• Strengthens working capital metrics (current ratio, quick ratio).

• Buys you optionality: the ability to invest in R&D, acquisitions, or marketing without running to your bank first.

But it’s a balancing act:

• Too little equity → Fragile, high-risk, vicious cycle of rising costs.

• Too much equity → Bloated, underperforming, diluted ROE.

Disclaimer:
This content is for informational and educational purposes only and should not be construed as financial, legal, or professional advice. Always consult with a qualified advisor before making any business or financial decisions. The author and publisher disclaim any liability for actions taken based on this content.

Talk soon,