Analyze the company’s capital structure

If you are a stock investor who likes companies with good fundamentals, then consider a strong balance sheet when looking for investment opportunities. By using three major types of metrics—working capital, asset performance, and capital structure—you can assess the strength of a company’s balance sheet and thus the quality of its investment.

The company’s wise use of debt and equity is a key indicator of a strong balance sheet. A healthy capital structure reflecting low debt levels and a large amount of equity is a positive indicator of investment quality. This article focuses on analyzing the balance sheet based on the company’s capital structure.

Key points

  • Capital structure refers to the company’s capital portfolio, including the combination of debt and equity.
  • Equity includes the company’s common stock and preferred stock plus retained earnings.
  • The composition of debt varies, but it usually includes short-term borrowings, long-term debts, operating leases and part of the redeemable preferred equity capital.
  • Important ratios for analyzing capital structure include debt ratio, debt-to-equity ratio and capitalization ratio.
  • The rating of a company by a credit agency helps to assess the quality of the company’s capital structure.

Capital structure terms

Capital Structure

The capital structure describes the combination of the company’s long-term capital, including the combination of debt and equity. Capital structure is a type of permanent capital that supports the company’s growth and related assets. Expressed by a formula, the capital structure is equal to debt plus total shareholder equity:

Capital structure = DO + TSE where: DO = debt obligation TSE = total shareholder equity begin{aligned} &text{Capital Structure} = DO + TSE \ &textbf{where:}\ &DO=text{debt }\ &TSE=text{total shareholders’ equity}\ end{aligned}

Capital Structure=DOh+TonsecondSecondWhere:DOh=debtTonsecondSecond=Total shareholders’ equity

You may hear that capital structure is also called “capitalization structure”, or simply “capitalization”.

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The equity component of the debt-equity relationship is the easiest to define. In the capital structure, equity includes the company’s common stock and preferred stock plus retained earnings. This is considered investment capital and appears in the shareholders’ equity portion of the balance sheet. Investment capital plus debt constitute the capital structure.

debt

The discussion of debt is not so simple. The investment literature often equates a company’s debt with its liabilities; however, there is an important distinction between operating liabilities and debt liabilities. The latter constitute the debt component of the capital structure, although investment research analysts disagree on what constitutes debt liabilities.

Many analysts define the debt component of the capital structure as the long-term debt of the balance sheet; however, this definition is too simplistic. On the contrary, the debt component of the capital structure should include short-term loans (notes payable), long-term debt, and two-thirds of the principal of operating leases and redeemable preferred stock (rule of thumb).

When analyzing a company’s balance sheet, it is best for experienced investors to use this comprehensive total debt figure.

Optimal capital structure

Ratio applied to capital structure

Generally speaking, analysts use three ratios to assess the strength of a company’s capital structure. The first two are popular indicators: debt ratio (total debt to total assets) And debt-to-equity (D/E) ratio (total debt to total shareholder equity). However, the third ratio, the capitalization ratio—(long-term debt divided by (long-term debt plus shareholders’ equity))—provides a key insight into the company’s capital position.

For debt ratios, more debt means less equity, and therefore a higher leverage position. The problem with this method of measurement is that it is too broad and gives equal weight to operating liabilities and debt liabilities.

The same criticism applies to debt-to-equity ratios. Current and non-current operating liabilities, especially the latter, represent obligations that the company will always assume. In addition, unlike debt, operating liabilities have no fixed principal or interest payments.

On the other hand, the capitalization ratio compares the debt component with the equity component of the company’s capital structure; therefore, it presents a more realistic picture. Expressed as a percentage, a lower number indicates a healthy equity buffer, which is always preferable to a high percentage of debt.

Optimal relationship between debt and equity

Unfortunately, there is no magical ratio of debt to equity that can be used as a guide. What defines a healthy mix of debt and equity varies according to the industry involved, the scope of the business, and the development stage of the company.

However, since it is best for investors to invest money in companies with strong balance sheets, the optimal balance should generally reflect lower debt levels and higher equity levels.

About leverage

In the financial sector, debt is a perfect example of a well-known two-edged sword. It is good to use leverage (debt) wisely. It increases the amount of financial resources available to the company for growth and expansion.

Not only is too much debt worrying, but too little debt may also be worrying. This may mean that the company is relying too much on its equity and not effectively using its assets.

With leverage, it is assumed that the income that management can obtain from borrowed funds is higher than the interest expenses and expenses paid for these funds. However, to successfully assume large amounts of debt, the company must maintain a reliable record of complying with its various borrowing commitments.

The problem of excessive leverage

Family too High leverage (excessive debt relative to equity) may eventually find that its creditors will restrict its freedom of action; otherwise, it may pay high interest costs and reduce profitability. In addition, during periods of unfavorable economic conditions, the company may have difficulty meeting its operating and debt liabilities.

Or, if the business sector is highly competitive, then competing companies can (and do) take advantage of debt-laden companies by swooping to grab more market share. Of course, the worst-case scenario may be that the company needs to declare bankruptcy.

Credit rating agency

Fortunately, there are many excellent resources that can help determine whether a company may be over leveraged. The main credit rating agencies are Moody’s, Standard & Poor’s (S&P), Duff Phelps and Fitch. These entities conduct formal risk assessments of the company’s ability to repay the principal and interest of debt, mainly bonds and commercial paper.

All ratings of credit agencies fall into one of two categories: investment grade or non-investment grade.

The credit ratings of companies from these institutions should appear in the footnotes of their financial statements. Therefore, as an investor, you should be very happy to see the high-quality ranking of the debt of the company you are considering as an investment opportunity, and likewise, if you see that the company you are considering has a poor rating, you should remain vigilant.

Bottom line

The company’s capital structure constitutes the equity and debt portfolio on its balance sheet. Although there is no specific level to determine what a healthy company is, a lower debt level and a higher equity level are preferred.

Various financial ratios help analyze the company’s capital structure, so that investors and analysts can easily understand the company’s comparison with its peers, and thus understand its financial status in the industry. Ratings provided by credit agencies can also help reveal the company’s capital structure.

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