Capital Structure: Balancing Risk and Reward

🛠 THE CFO EFFECT PLAYBOOK (Part II)

Capital structure in plain English

At its simplest, capital structure is how you fund your business and its growth.

It’s the mix of:

• Debt: borrowed money with an obligation to repay principal + interest.

• Equity: owner/investor money; no repayment obligation, but costly in dilution.

Most leaders obsess over cheapest capital.
Great CFOs focus on the right capital for:

• Business model

• Stage of growth

• Risk profile

• Strategic goals

Think of it like building an F1 race car:

• Too little horsepower (debt) and you crawl while competitors fly past.

• Too much and you spin out on the first sharp turn.

The Risk–Return trade-off

Debt is a force multiplier.

• In good times: It amplifies returns, boosts ROE, and makes equity holders look brilliant.

• In bad times: It magnifies losses, compresses margins, and forces management into short-term survival mode.

Smart CFOs manage leverage like a thermostat.

They constantly adjust up or down to keep the business in its optimal performance zone.

They understand that the “right” level of debt isn’t static. It shifts with:

• Economic conditions

• Industry cycles

• Internal performance trends

Your capital structure dashboard

1️. Debt-to-EBITDA

Definition: How many years of EBITDA it would take to repay debt.

Why it matters:
It’s a blunt but powerful measure of leverage sustainability.

Rules of thumb:

• 2–3x: Most senior lenders are comfortable with this level. If cash flows are stable and predictable, you can even stretch it to 3.5 to 4x. This is the cheapest debt you can have.

• 4–5x: This falls into a sub-debt category. It’s riskier and results in a higher interest rate.

• 6x: This falls in a more riskier debt category which requires senior lender approval and has a higher interest rate than the sub-debt category.

Strategic watch-out: Don’t just look at the number. Look at the trend. A move from 3x to 5x in 12 months signals risk.

2️. Debt-to-Equity

Definition: Compares borrowed capital to capital invested and retained earnings.

Why it matters:
Shows your leverage relative to the equity cushion protecting lenders.

It also shows how much skin in the game do the owners have.

Banks require a minimum ratio because they don’t want to take a shareholder risk while getting compensated like a senior lender.

Strategic lens:

• High ratios can drive ROE higher but only if returns exceed your cost of debt.

• A rising ratio with flat or declining ROE is a red flag.

• A too low ratio is not great for the business. It means that you’re not taking advantage of the debt component and you’re reducing the return on equity.

If the company is growing faster than its capacity to generate cash flow, you should introduce the debt component.

If you generate a 25% ROI and the interest rate is at 6% and you can get a return of 12% in the stock market, it’s better to invest the excess cash in the stock market, borrow at 6% and invest in stocks.

The bank is usually comfortable with a Debt to Equity ratio below 75%.

 3️. Debt Service Coverage Ratio (DSR)

Definition: EBITDA divided by (Yearly Capital + Interest Expense).

Why it matters:
Measures your ability to service your capital and interest due within a year.

Rules of thumb:

• >2x: Very Comfortable.

• 1.25x: Good.

• <1.25x: You’re edging into a dangerous zone especially if rates rise or earnings fall.

Red Flags to Watch For

• Debt growing faster than EBITDA.

• Declining DSC despite stable revenues (cost creep or margin compression).

• Using short-term debt to fund long-term assets (maturity mismatch).

Practical 3-Step Capital Structure Health Check

Run this on your business this week:

Step 1 – Pull the Numbers
Get your Debt-to-EBITDA, Debt-to-Equity, and DSC from your latest close.

Step 2 – Benchmark
Compare to:

• Industry averages.

• Your own historical 3-year range.

Step 3 – Stress-Test
Model a 20% EBITDA drop.
Ask:

• Does Debt-to-EBITDA jump into high-risk territory?

• Does DSC fall below 1.25x?
  If yes, your capital structure is brittle, rebalance before market conditions force you to.

Next Week’s Episode:

🔜 Why “Cheap” Capital Can Be the Most Expensive Mistake You Make 

On paper, 5% money looks better than 12% money.
But in reality, “cheap” capital can be the most expensive mistake you’ll ever make.

Why? Because cost isn’t just about interest rates.

It’s about flexibility, risk, and strategic fit.
Plenty of companies have been crushed not by expensive money, but by cheap money with the wrong structure.

Next Sunday, I’ll break down exactly how to evaluate financing the way top CFOs do:

✅ The “Financing Fit Matrix”: how to match capital type to your business model, growth stage, and risk profile
✅ Why over-leveraging destroys resilience and under-leveraging destroys growth
✅ The 4-point CFO checklist for stress-testing financing before you sign
✅ Real examples of how “cheap” debt triggers expensive covenant breaches and liquidity traps

Because the right capital structure is about maximizing flexibility, protecting downside risk, and keeping your company free to scale.

If you’re ready to stop thinking about cost in isolation you can’t miss this episode.

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,