is expanding and profitable, but it is detrimental when the business enters a contraction phase. The interest on the debt must be paid regardless of the level of the company's operating income, or bankruptcy may be the result. If the firm does not prosper and profits do not meet management's expectations, too much debt (i.e., too much leverage) increases the risk that the firm may not be able to pay its creditors. At some point this makes investors apprehensive and increases the firm's cost of borrowing or issuing new equity. Optimal capital structure It is important that a company's management recognizes the risk inherent in taking on debt, and maintains an optimal capital structure with an appropriate balance between debt and equity. An optimal capital structure is one that is consistent with minimizing the cost of debt and equity financing and maximizing the value of the firm. Internal policy decisions with respect to capital structure and debt ratios must be tempered by a recognition of how outsiders view the strength of the firm's financial position. Key considerations include maintaining the firm's credit rating at a level where it can attract new external funds on reasonable terms, and maintaining a stable dividend policy and good earnings record. Term structure of debt in capital structure Once management has decided how much debt should be used in the capital structure, decisions must be made as to the appropriate mix of short-term debt and long-term debt. Increasing the percentage of short-term debt can enhance a firm's financial flexibility, since the borrower's commitment to pay interest is for a shorter period of time. But short-term debt also exposes the firm to greater refinancing risk. Therefore, as the percentage of short-term debt in a firm's capital structure increases, equity holders will expect greater returns on equity to compensate for the increased risk, according to a 2022 article in The Journal of Finance. Seniority In the event of bankruptcy, the seniority of the capital structure comes into play. A typical company has the following seniority structure listed from most senior to least: senior debt, including mortgage bonds secured by specifically pledged property, subordinated (or junior) debt, including debenture bonds which are dependent upon the general credit and financial strength of the company for their security, preferred stock, whose holders are entitled to have their claims met before those of common stockholders, and equity, which includes common stock