PurposeIn this paper, the author examines how capital structure (relative to target) affects firm innovation.Design/methodology/approachThe author uses cross-sectional OLS regressions (for each year of data) to determine whether a firm is above or below its target debt level (in that year) and then uses fixed effects OLS regressions with panel data to examine the impact of having leverage above or below the firm's target on its innovation activity.FindingsThe author shows that firms with below-target debt innovate more in terms of number of patents granted and have better quality innovations in terms of citation counts of patents and in terms of economic value of patents. The results hold for sample splits based on firm age, firm size and access to external finance. The author also shows that the findings are not driven by the negative correlation between leverage and innovation measures. Overall, the results indicate that it is not the actual level of leverage that impacts innovation; the relevant factor that impacts firm innovation is whether a firm is above or below its leverage target.Originality/valueThe author extends the literature on financing innovation by linking leverage target with firm innovation. Findings of this paper also provide supporting evidence that capital structure plays an important role on firm innovation and supplements prior literature that shows the importance of debt in financing firm innovation.