Debt, equity and capital structure: how funding changes returns and risk
A business can be funded by lenders, who are promised a fixed return, or by owners, who get what is left. The mix changes the return to owners and the risk they carry. This lesson lets you change the mix and then reads Apple's balance sheet, where book debt looks high, the shares are worth far more than the books say, and cash exceeds borrowing.
- Level
- Beginner
- Reading time
- About 27 minutes
- Know this first
- NPV, IRR and payback
By the end you will be able to:
- explain how debt and equity differ in claim, cost, risk and control
- work out the return to owners with and without borrowing
- say when borrowing raises the return and when it lowers it
- read a company's leverage on book, market and net-debt bases
Where a company's money comes from
Every business needs money to buy equipment, hold stock and pay people before sales arrive. That money comes from two kinds of source. Debt is borrowed: a bank loan, a bond or short-term paper. The lender is promised fixed interest and the return of the amount lent, whether the business does well or badly. Equity is contributed by the owners, either as money paid in for shares or as profit kept in the business. Owners are promised nothing. They receive what is left after everyone else has been paid, which may be a great deal or nothing at all.
The mix of the two is the company's capital structure. It is one of the main choices finance managers make, because the same business earns different returns for its owners, and carries different risks, depending on how it is funded. This lesson sets out the trade-off, lets you change the mix, and then reads Apple's balance sheet, which has more debt than most people expect and almost none of the risk that usually comes with it.
Debt and equity compared
The two differ in what they promise, what they cost and what happens in bad times.
- Claim. Lenders have a fixed claim on interest and repayment, and they rank ahead of owners if the business fails. Owners have a residual claim on whatever remains.
- Cost to the company. Debt usually costs less, because lenders carry less risk and are paid first. Equity must offer a higher expected return to attract owners, since they carry the risk. The next lessons put numbers on both.
- Tax. In most countries interest is deducted before profit is taxed, while dividends are not. This gives debt a tax advantage, covered in the lesson on the cost of debt.
- Risk. Interest must be paid in good years and bad. Too much debt can force a business into default even when its operations are sound. Dividends can be cut without a legal default.
- Control. Shares carry votes. New equity dilutes existing owners. Debt does not, though lenders may set conditions called covenants.
Change the funding, watch the return to owners
The company below is funded by $1,000,000 of capital. Set how much operating profit the business earns before interest and tax, what share of the capital is borrowed, the interest rate and the tax rate. The left page shows the split of the money and what is left for the owners. The right page shows the return on the owners' money, the return the business would give with no debt, how many times operating profit covers interest, and earnings per share. Shares are valued at $10 of owners' money each. All of it is made up for teaching.
With $400,000 borrowed and $600,000 from owners, interest is $24,000 and profit after tax is $57,000, a return on owners' money of 9.50%. That is higher than the 7.50% earned with no debt: borrowing at 6.0% pays because the business earns more on the money than the debt costs. Operating profit covers the interest 4.17 times.
Four experiments. First, move the borrowing to 0%. The return on owners' money is 7.50%, and earnings per share are $0.75. Now put it back to 40%: the return rises to 9.50% and earnings per share to $0.95. Borrowing at 6% pays because the business earns 7.50% on its capital after tax, more than the 4.50% the debt costs after tax. Second, raise borrowing to 80% and leave the rest. The return climbs to 19.50%, and operating profit covers interest only 2.08 times. Third, cut operating profit to $40,000 with 40% borrowed. The business now earns 3.00% after tax on its capital, less than the debt costs, and the return to owners is 2.00%, below the 3.00% it would be with no debt. Fourth, set operating profit to $50,000 and borrowing to 80%: interest takes almost everything, and the owners' return falls to 0.75%. Leverage magnifies results in both directions.
Financial leverage: the two-sided effect
The effect in the experiments has a simple rule. Borrowing raises the return to owners if the business earns more on its capital, after tax, than the debt costs after tax. If it earns less, borrowing lowers the return. The size of the swing depends on how much is borrowed. This is called financial leverage, and it is the same equity multiplier met in the lesson on DuPont analysis, now seen from the funding side.
The second line is the gain or loss from borrowing. When the business earns 7.50% and the debt costs 4.50% after tax, each dollar borrowed adds the difference, 3.00 points, and with 0.67 dollars borrowed for each dollar of equity the gain is 2.00 points: from 7.50% to 9.50%. Leverage does not create returns. It moves risk to owners and, when things go well, rewards them for carrying it.
Why too much debt is dangerous
Interest has to be paid. Interest cover, operating profit divided by interest, shows how much room there is. At 40% borrowing the default business covers its interest 4.17 times, so operating profit could fall by about 76% before the interest was no longer met. At 80% borrowing the cover is 2.08 times, and a fall of about 52% would leave interest uncovered. Lenders know this and charge more as borrowing rises, and may refuse to lend at all. The lesson on debt and coverage ratios showed the same measure on the accounts of Titan and Info Edge. Capital structure decisions are therefore a balance: the cheap, tax-advantaged funding of debt against the risk of being unable to pay it. Businesses with steady, predictable cash flow, such as utilities, can carry more debt. Businesses with uncertain income, such as young technology firms, usually carry little.
Apple's capital structure
Apple's balance sheet at 27 September 2025 shows what a large, highly profitable company does with this choice. Debt is commercial paper, which is short-term borrowing, and term debt, which is its longer-term notes. Equity is total shareholders' equity. The first column uses the amounts printed on the balance sheet, called book values. The second shows how the same debt compares with the market value of the shares.
| 27 September 2025, millions of US dollars | Book values | With shares at market value |
|---|---|---|
| Commercial paper | 7,979 | |
| Term debt, due within a year | 12,350 | |
| Term debt, due later | 78,328 | |
| Total debt | 98,657 | 98,657 |
| Shareholders' equity: book value, and market value of shares held outside the company | 73,733 | 3,253,431 |
| Debt as a share of debt plus equity | 57.2% | 2.9% |
| Debt for each dollar of equity | 1.34 | 0.030 |
| Cash and marketable securities | 132,420 | 132,420 |
| Net cash (cash and securities less debt) | 33,763 | 33,763 |
Apple has $98,657 million of debt and $73,733 million of book equity. Measured in book values, borrowing is 57.2% of the two together, and debt is 1.34 times equity. That is high. But the market tells a different story. At 28 March 2025 the shares held by people other than insiders were valued at $3,253,431 million, about 44 times Apple's book equity. Against that, debt is only 2.9% of the combined value of debt and equity. And Apple holds $132,420 million of cash and marketable securities, more than its debt, so it has net cash of $33,763 million.
The gap between book and market equity comes from two things. Accounting records what has been invested and kept, not what a business is worth. And Apple spends heavily on buying back its own shares, which lowers book equity: in fiscal 2025 it spent $90,711 million on repurchases, more than its whole book equity of $56,950 million at the start of the year. The result is a return on equity that looks extraordinary. Net income of $112,010 million is 152% of year-end book equity, and the assets are 4.87 times equity. It would be a mistake to read that as risky leverage. It follows from a very profitable business paying out most of its profit and a small book equity base, while holding more cash than debt. With operating profit of $133,050 million and expected interest on its notes of about $2.6 billion over the next 12 months, operating profit covers interest about 51 times. The danger the experiments show, owners hurt because interest swallows profit, is far from Apple's situation.
Why borrow at all with so much cash? A company may find it cheaper, after tax and after the cost of bringing cash home from abroad, to borrow than to sell investments. It may also want to keep its borrowing capacity in use and its credit record visible in the market. Apple does not say which of these applies. The point for the lesson is that book leverage, market leverage and net debt can give three different answers for the same company, so a statement about capital structure should say which one it means.
What these measures cannot tell you
- The calculator is a simplification. The interest rate is fixed whatever the amount borrowed. In practice lenders raise the rate as debt grows.
- Book values are history. Book equity records what was put in and kept, so it can be far from market value, as Apple shows.
- Profit is not constant. The calculator uses one level of operating profit. In real life profit varies, and leverage multiplies the variation.
- There is no single best mix. The right level depends on how stable the business is, how much of its assets can be pledged, and how it is taxed.
- Debt is not only borrowing. Leases, pensions and other obligations act like debt. Apple's lease liabilities are not in the table above, and including them would raise its debt.
Three funding mixes at book value
Capital structure is the mix of debt and equity a company uses to fund itself. The table measures it at book value, using the amounts on the balance sheet, for Apple, Microsoft and Toyota. "Borrowings" here means interest-bearing debt only. The last column shows the other liabilities, such as supplier credit, prepayments and provisions, that also fund assets but do not carry interest.
| Latest balance sheet, millions | Borrowings | Equity | Borrowings as a share of borrowings plus equity | Other liabilities as a share of total assets |
|---|---|---|---|---|
| Apple | $98,657 | $73,733 | 57.2% | 52.0% |
| Microsoft | $43,151 | $343,479 | 11.2% | 37.5% |
| Toyota | ¥38,792,879 | ¥36,878,913 | 51.3% | 19.2% |
Borrowings are 11.2% of Microsoft's borrowings and equity, 51.3% of Toyota's and 57.2% of Apple's. At first glance Apple looks the most indebted. It is not: its book equity is small because of share repurchases, and a book measure of structure can give the wrong picture. At the price the market placed on Apple's shares, the equity is worth about $3,253,431 million, taken from the market value of the shares held by non-affiliates stated on the cover of its annual report at 28 March 2025, against book equity of $73,733 million, a ratio of about 44 to one. Measured at market value, the share of borrowings in Apple's funding would be a few percent. The lesson on the cost of capital returns to this point, because the weights in that calculation should be market values.
Interest-free funding
The last column is the part that the debt-to-equity ratio leaves out. At Apple, 52.0% of total assets is funded by liabilities that carry no interest, and at Microsoft 37.5%. Most of this is the supplier credit and customer prepayments from the lessons on working capital and accruals. It does not need to be repaid in cash in the same way as a loan, but it also is not free: it depends on the company continuing to buy from the same suppliers on the same terms and to sell to customers who pay in advance. A funding mix that looks conservative can be less so if a large part of it is that kind of credit.
Why the mix differs between countries
Companies in different economies have tended to rely on different sources of finance. In some countries, banks have historically been the main lenders to large companies, and in others the bond and equity markets have been the main channel, and tax law has an influence too: where interest is deductible and dividends are not, debt is cheaper. The company's own business matters as much. Toyota's finance arm borrows to lend, and so a part of its debt is the funding for its customers' vehicles and not for its factories, as the leverage lesson showed. When comparing capital structures across borders, compare companies in the same industry and separate out any financial subsidiary.
Common mistakes
Assuming debt is always cheaper and therefore better
Debt costs less per dollar, but it makes the equity riskier. The return to owners rises only if the business earns more than the debt costs, and it falls when it does not.
Comparing book debt to equity across companies
A company that buys back shares has less book equity and looks more leveraged. Apple's book ratio is 1.34 to 1, though it has net cash.
Ignoring cash
Debt of $98,657 million looks large until set against $132,420 million of liquid assets. Net debt, debt less cash, is often the more useful figure.
Ignoring tax in the comparison
The returns on capital and on debt must both be after tax. Comparing a pre-tax rate with a post-tax return gives the wrong answer.
Treating a high return on equity as proof of a good business
It can come from leverage, a small equity base or buybacks. Use the DuPont split to see where it comes from.
Try it yourself
1. A firm has $1,000,000 of capital, borrows 50% at 8% and earns operating profit of $120,000. Tax is 25%. What is the return on owners' money?
Show the working
Interest = $500,000 × 8% = $40,000. Profit before tax = 120,000 − 40,000 = 80,000. Tax = 20,000, so profit after tax = 60,000. Equity = $500,000. Return = 60,000 ÷ 500,000 = 12.0%. With no debt it would be 120,000 × 0.75 ÷ 1,000,000 = 9.0%.
2. Interest cover is operating profit divided by interest. If operating profit is $120,000 and interest $40,000, what is the cover, and by what share could operating profit fall before interest is no longer covered?
Show the working
Cover = 120,000 ÷ 40,000 = 3.0 times. Profit can fall by two-thirds, to $40,000, before it just meets the interest. That is a cushion, not a guarantee.
3. A business earns 5% after tax on its capital. It can borrow at 8% before tax, with tax at 25%. Would borrowing raise or lower the owners' return?
Show the working
After-tax cost of debt = 8% × 0.75 = 6%, which is above the 5% earned. Each borrowed dollar loses a point, so borrowing lowers the owners' return.
4. Apple has debt of $98,657 million and cash and securities of $132,420 million. What is its net debt, and what does the sign say?
Show the working
98,657 − 132,420 = −33,763, so Apple has net cash of $33,763 million. Gross borrowing looks large, but its holdings of cash and securities are bigger.
Where this is used
- A chief financial officer chooses between a bond issue, a bank loan and a share issue to fund an expansion.
- A lender sets limits on borrowing, such as a maximum ratio of debt to equity or a minimum interest cover.
- A credit rating agency judges a company's ability to carry its debt by its leverage and cover.
- An investor reads a high return on equity and checks how much of it comes from borrowing.
Key terms
- Capital structure
- The mix of debt and equity a company uses to fund itself.
- Debt
- Borrowed money that carries a fixed claim for interest and repayment.
- Equity
- The owners' stake: money paid in for shares plus profit kept in the business.
- Financial leverage
- The use of borrowed money, which magnifies both gains and losses for owners.
- Interest cover
- Operating profit divided by interest expense.
- Net debt
- Debt less cash and liquid investments. Negative net debt means net cash.
- Commercial paper
- Short-term borrowing by a company, usually repaid within a year.
- Covenant
- A condition in a loan agreement, such as a limit on further borrowing.
Questions people ask
What is the best debt to equity ratio?
There is none. The right level depends on how stable the company's income is, its industry, and how lenders see it. Compare with similar companies and with the company's own history.
Why do companies keep cash and still borrow?
Reasons include tax, the cost of moving cash between countries, keeping a visible credit record, and keeping cash for emergencies. A company's report may or may not say which applies.
Is equity free because there is no interest?
No. Owners expect a return, and it is higher than the interest on debt because they carry more risk. The lesson on the cost of equity measures it.
Does a buyback count as debt or equity?
A buyback reduces equity, since the company is giving cash back to owners. If it is paid for with borrowing, it replaces equity with debt.
Sources and review
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of the income statement, balance sheet and cash flow figures.
- Apple Inc., Form 10-K for the fiscal year ended 27 September 2025. Source of the market value of shares held by non-affiliates on the cover and the expected interest on the notes in the discussion of liquidity.
- Corporate Finance Institute, Capital structure, for the definition and the debt and equity trade-off.
- AnalystPrep, Measures of profitability, for the use of required returns in financing decisions.
- Apple Inc., Form 8-K, Exhibit 99.1: fourth quarter and full-year fiscal 2025 results, filed with the US Securities and Exchange Commission. Source of Apple's statements.
- Apple Inc., Form 10-K for the fiscal year ended 27 September 2025. Source of the market value of shares held by non-affiliates at 28 March 2025, stated on the cover page.
- Microsoft Corporation, Form 8-K, Exhibit 99.1: fourth quarter and fiscal year 2025 results, filed with the US Securities and Exchange Commission. Source of Microsoft's statements.
- Toyota Motor Corporation, FY2025 Financial Summary (IFRS, unaudited, in millions of yen), furnished to the US Securities and Exchange Commission on Form 6-K. Source of Toyota's statements.
How the numbers were checked: Apple's income statement, balance sheet and cash flow figures were tied out by code: sales less cost of sales, expenses, other income and tax give net income in both years, assets equal liabilities plus equity, and earnings per share equal net income divided by diluted shares. The term debt matched the amount in the debt note. The calculator was tested against separate arithmetic for more than 1,700 combinations, including that borrowing raises the owners' return exactly when the after-tax return on capital exceeds the after-tax cost of debt.