Analyze the capital structure of a company
If you are an equity investor who enjoys companies with good fundamentals, a strong balance sheet is important to consider when researching investment opportunities. By using three broad types of metrics (working capital, asset performance, and capital structure), you can assess the strength of a company’s balance sheet, and therefore the quality of its investments.
The judicious use of a company’s debt and equity is a key indicator of a strong balance sheet. A healthy capital structure that reflects a low level of debt and a high amount of equity is a positive sign of the quality of investments. This article focuses on the analysis of the balance sheet according to the capital structure of a company.
Key points to remember
- Capital structure refers to the composition of a company’s capital, which is a combination of debt and equity.
- Equity consists of the common and preferred shares of a company, as well as retained earnings.
- What constitutes debt varies, but generally includes short-term borrowings, long-term debt and a portion of the principal amount of operating leases and redeemable preferred shares.
- Important ratios for analyzing capital structure include leverage ratio, leverage ratio, and capitalization ratio.
- The ratings that credit bureaus assign to businesses help assess the quality of a company’s capital structure.
Capital structure terminology
The capital structure
Capital structure describes the long-term capital composition of a business, which consists of a combination of debt and equity. Capital structure is a type of permanent financing that supports the growth of a business and related assets. Expressed as a formula, the capital structure is equal to debt obligations plus total equity:
The capital structure=DO+TSEor:DO=debt securitiesTSE=total equity
You can hear the capital structure also called “capitalization structure” or simply “capitalization”.
The equity portion of the debt-equity relationship is the easiest to define. In a capital structure, equity consists of the common and preferred shares of a company as well as retained earnings. This is considered as invested capital and appears in the equity portion of the balance sheet. Invested capital plus debt includes the capital structure.
A discussion of debt is less straightforward. The investment literature often equates a company’s debt with its liabilities; however, there is an important distinction between operational liabilities and debt liabilities. It is the latter that forms the debt component of the capital structure, although investment research analysts disagree on what constitutes a debt liability.
Many analysts define the debt component of the capital structure as the long-term debt of a balance sheet; however, this definition is too simplistic. Rather, the debt portion of a capital structure should consist of short-term borrowings (notes payable), long-term debt, and two-thirds (rule of thumb) of the principal amount of operating leases and preferred shares. refundable.
When analyzing a company’s balance sheet, seasoned investors would be wise to use this full figure for total debt.
Optimal capital structure
Ratios applied to the capital structure
In general, analysts use three ratios to assess the strength of a company’s capital structure. The first two are popular measures: the debt ratio (total debt to total assets) and the debt ratio (D / E) (total debt to total equity). However, it is a third ratio, the capitalization ratio – (long-term debt divided by (long-term debt plus equity)) – that provides key information about a company’s capital position.
With the debt ratio, more liabilities means less equity and therefore indicates a more indebted position. The problem with this measure is that it is too broad in scope and gives equal weight to operational liabilities and debts.
The same criticism applies to the debt ratio. Current and non-current operating liabilities, especially the latter, represent obligations that will be with the business forever. In addition, unlike debt, there are no fixed payments of principal or interest associated with operational liabilities.
On the other hand, the capitalization ratio compares the debt component to the equity component of a company’s capital structure; thus, it presents a truer picture. Expressed as a percentage, a low number indicates a healthy capital buffer, which is always more desirable than a high percentage of debt.
Optimal relationship between debt and equity
Unfortunately, there is no magic debt-to-equity ratio to use as a guide. What defines a healthy mix of debt and equity varies depending on the industries involved, the line of business and the stage of development of the company.
However, since investors are better positioned to invest their money in companies with strong balance sheets, it makes sense that the optimal balance generally reflects lower debt levels and higher levels of equity.
In finance, debt is a prime example of the proverbial double-edged sword. The judicious use of leverage (debt) is good. It increases the number of financial resources available to a business for its growth and expansion.
Not only is too much debt a cause for concern, too little debt can be too. This can mean that a business is relying too much on its equity and not using its assets efficiently.
With leverage, the assumption is that management can earn more on borrowed funds than they would pay in interest and fees on those funds. However, to successfully support a large amount of debt, a business must maintain a strong record of compliance with its various borrowing commitments.
The problem with too much leverage
A company too highly indebted (too much debt compared to equity) could end up seeing its creditors restrict its freedom of action; or it could experience a decline in profitability due to the payment of high interest charges. In addition, a business may have difficulty meeting its operating obligations and debt during times of adverse economic conditions.
Or, if the business sector is extremely competitive, then competing firms could (and do) take advantage of indebted firms by rushing to grab more market share. Of course, the worst-case scenario could be that a business goes bankrupt.
Fortunately, however, there are some great resources that can help determine if a business may be in too much debt. The main rating agencies are Moody’s, Standard & Poor’s (S&P), Duff & Phelps and Fitch. These entities perform formal assessments of the risks associated with a company’s ability to repay principal and interest on debt securities, primarily bonds and commercial paper.
All credit rating agency ratings fall into one of two categories: investment grade or non-investment grade.
A company’s credit ratings from these agencies should appear in the footnotes of its financial statements. So, as an investor you should be happy to see high quality rankings on the debt of the companies you are considering as investment opportunities, similarly you should be wary if you see poor ratings on the companies you are considering. you consider.
The bottom line
A company’s capital structure is the mix of equity and debt on its balance sheet. While there is no specific level of each that determines what a healthy business is, lower levels of debt and higher levels of equity are preferred.
Various financial ratios help analyze a company’s capital structure, making it easy for investors and analysts to see how a company stacks up against its peers and therefore its financial standing in its industry. Ratings provided by credit bureaus also help shed light on a company’s capital structure.