The connection between capital structure and firm value comes from the former financing activities that increase the latter. Capital structure is a mix of operating funds, debt financing, and equity financing that pays for new projects or activities that increase revenues and a firm’s economic wealth. For example, starting a new product line may be extremely costly for a business; through the use of external funds and an efficient production process, however, it can be done properly. A company’s capital structure and firm value may be one of the most scrutinized parts of a balance sheet. This is true because those who loan the company money through debt or equity financing want to ensure they will receive adequate financial remuneration for an investment.
A company’s firm value may also carry the name economic value, which is usually the difference between total assets and total liabilities. The result is the true economic value the company generates through business activities. Capital structure and firm value has a connection to physical assets on the balance sheet as these items are usually the result of funds from external sources. In some cases, it is possible that the total liabilities of a firm are higher than the total assets listed on the balance sheet. The end result is a negative total economic value due to inefficient financial processes resulting from business activities.
Two different financial ratios exist for measuring the connection between a company’s capital structure and firm value: return on debt and return on equity. Each formula focuses on a specific type of outside funds that may be in use for payment of large projects or business activities. Each formula has net income or net profit as the numerator; the denominator is either total long-term debt or total equity, depending on the type of external funds in use. The result is a percentage of return, with higher percentages meaning the company is earning more money on the funds and is therefore more efficient. Creating a combination formula for measuring the use of both types of funds on a project is also possible through slight changes in the calculations.
Not all companies have connections between capital structure and firm value. The obvious issue at hand is the lack of capital funding that may exist in a business. No capital structure, therefore, equals zero need for measuring firm value in this manner. Additionally, smaller companies that do not have the ability to issue stock only have debt in their capital structures. This can make the measuring of capital structure and firm value slightly less important than when stockholders have vested interests in a business.