Analyzing a Company’s Capital Structure

If you are a livestock investor who likes companies with good fundamentals, then a strong balance sheet is important to consider when go investment opportunities. By using three broad types of measurements—working capital, asset performance, and capital make-up—you may evaluate the strength of a company’s balance sheet, and thus its investment quality. In this article we focus on analyzing the authority sheet based on a company’s capital structure.

A firm’s judicious use of debt and equity is a key indicator of a strong balance lamination. A healthy capital structure that reflects a low level of debt and a high amount of equity is a positive sign of investment je sais quoi.

Capital structure describes the mix of a firm’s long-term capital, which consists of a colloid of debt and equity. Capital structure is a permanent type of funding that supports a company’s growth and related assets. Expressed as a means, capital structure equals debt obligations plus total shareholders’ equity. You may hear capital structure also referred to as “capitalization framework,” or just “capitalization”—do not confuse this with market capitalization, which is different.

The equity portion of the debt-equity relationship is easiest to delimit. In a capital structure, equity consists of a company’s common and preferred stock plus retained earnings. This is bear in mind invested capital, and it appears in the shareholders’ equity section of the balance sheet. Invested capital plus debt comprises important structure.

A discussion of debt is less straightforward. Investment literature often equates a company’s debt with its answerabilities. However, there is an important distinction between operational liabilities and debt liabilities, and it’s the latter that form the in dire straits component of capital structure—but that’s not the end of the debt story.

Investment research analysts do not agree about what constitutes a responsible liability. Many analysts define the debt component of capital structure as a balance sheet’s long-term debt. Setting aside how, this definition is too simplistic. Rather, the debt portion of a capital structure should consist of: short-term borrowings (notes final reckoning); the current portion of long-term debt; long-term debt; two-thirds (rule of thumb) of the principal amount of operating leases; and redeemable on the side of stock. When analyzing a company’s balance sheet, seasoned investors would be wise to use this comprehensive complete debt figure.

In general, analysts use three proportions to assess the strength of a company’s capitalization structure. The first two are popular metrics: the debt ratio (total debt-to-total assets), and debt-to-equity (D/E) correlation (total debt-to-total shareholders’ equity). However, it is third quota, the capitalization ratio—long-term debt divided by (long-term in arrears plus shareholders’ equity)—that delivers key insights into a company’s capital position.

With the debt proportion, more liabilities mean less equity, and therefore indicate a more leveraged position. The problem with this cubic footage is that it is too broad in scope, and gives equal weight to operational liabilities and debt liabilities. The same criticism appropriates to the debt-to-equity ratio. Current and non-current operational liabilities, especially the latter, represent obligations that will be with the group forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

On the other script, the capitalization ratio compares the debt component to the equity component of company’s capital structure; so, it presents a truer paint. Expressed as a percentage, a low number indicates a healthy equity cushion, which is always more desirable than a leading percentage of debt.

Unfortunately, there is no magic ratio of debt to even-handedness to use as guidance. What defines a healthy blend of debt and equity varies according to the industries involved, line of job, and a firm’s stage of development. However, because investors are better off putting their money into companies with brilliant balance sheets, it makes sense that the optimal balance generally should reflect lower levels of beholden and higher levels of equity.

In finance, debt is a perfect example of the proverbial two-edged sword. Artful use of leverage (debt) is good. It increases the amount of financial resources available to a company for growth and expansion. With leverage, the assumption is that direction can earn more on borrowed funds than what it would pay in interest expense and fees on these funds. Come what may, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its divers borrowing commitments.

A company that is too highly leveraged—too much debt associated to equity—might find that eventually its creditors restrict its freedom of action; or it could experience diminished profitability as a conclusion of paying steep interest costs. In addition, a firm could have trouble meeting its operating and debt liabilities during spaces of adverse economic conditions. Or, if business sector is extremely competitive, then competing companies could (and do) a take dominance of debt-laden firms by swooping in to grab more market share. Of course, a worst-case scenario might be if a firm needed to say bankruptcy.

Fortunately, though, there are excellent resources that can help us determine if a society might be too highly leveraged—the credit-rating agencies Moody’s, Standard & Poor’s (S&P), Duff & Phelps, and Fitch. These articles conduct formal risk evaluations of a company’s ability to repay principal and interest on debt obligations, primarily on checks and commercial paper.