Small and medium scale enterprises (SMEs) are drivers of economic growth in developed and emerging economies like Uganda. Although they constitute a large proportion of businesses, the SMEs’ financial performance has been unstable over the years, and in extant literature this issue has been attributed to capital structure and other financing decisions. Empirical evidence indicates that more than 50% of SMEs in Uganda cease their operations within the first three years of operation, citing financial capacity issues such as inadequate liquidity. Hence, the aim of this work was to determine the mediating effect of financial capacity in the relationship between SME capital structure and financial performance. The study design was anchored in the agency, free cash flow, and stakeholder theories and the relevant data were gathered via a cross-sectional survey. A stratified sampling method was used to identify SMEs operating in the target area, and one respondent was purposively selected from every chosen SME. Although questionnaires were sent to 453 SMEs, only 423 valid questionnaires were obtained and were subjected to further analyses. Data were analyzed using descriptive statistics and multivariate analysis. The mediation test results indicate a partial but statistically significant mediation effect of financial capacity in the capital structure−financial performance relationship. We thus conclude that high levels of financial capacity strengthen the effect of capital structure on the financial performance of SMEs. Consequently, we recommend that SMEs maintain optimal levels of liquidity as well as financial solvency to optimize financial performance.