Evaluating a Company's Capital Structure
For stock investors that favor companies with good fundamentals, a
"strong" balance sheet is an important consideration for investing in
a company's stock. The strength of a company's balance sheet can be evaluated
by three broad categories of investment-quality measurements: working capital adequacy; asset performance; and capital structure.
In this article, we'll look at evaluating balance sheet strength based on the
composition of a company's capital structure.
A company's capitalization (not to be confused with market capitalization)
describes the composition of a company's permanent or long-term capital, which
consists of a combination of debt and equity. A healthy proportion of equity capital, as
opposed to debt capital, in a company's capital structure is an indication of
financial fitness.
Clarifying Capital
Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to
define. In a company's capital structure, equity consists of a company's common
and preferred stock plus retained earnings, which are summed up in the shareholders' equity
account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's
capitalization, i.e. a permanent type of funding to support a company's growth
and related assets.
A discussion of debt is less straightforward. Investment literature
often equates a company's debt with its liabilities.
Investors should understand that there is a difference between operational and
debt liabilities – it is the latter that forms the debt component of a
company's capitalization – but that's not the end of the debt story.
Among financial analysts and investment research services, there is no
universal agreement as to what constitutes a debt liability. For many analysts,
the debt component in a company's capitalization is simply a balance sheet's long-term debt. This
definition is too simplistic. Investors should stick to a stricter
interpretation of debt where the debt component of a company's capitalization
should consist of the following: short-term borrowings (notes payable); the current portion of long-term
debt; long-term debt; two-thirds (rule of thumb) of the principal
amount of operating leases;
and redeemable preferred stock. Using a comprehensive total debt figure is a
prudent analytical tool for stock investors.
It's worth noting here that both international and U.S. financial
accounting standards boards are proposing rule changes that would treat
operating leases and pension "projected-benefits" as balance sheet
liabilities. The new proposed rules certainly alert investors to the true
nature of these off-balance sheet obligations that have all the earmarks of debt.
Is There an Optimal
Debt-Equity Relationship?
In financial terms, debt is a good example of the proverbial two-edged
sword. Astute use of leverage (debt) increases the
amount of financial resources available to a company for growth and expansion.
The assumption is that management can earn more on borrowed funds than it pays
in interest expense and fees on these funds. However, as successful as this formula
may seem, it does require that a company maintain a solid record of complying
with its various borrowing commitments.
A company considered too highly-leveraged (too much debt versus equity)
may find its freedom of action restricted by its creditors and/or may have its
profitability hurt as a result of paying high interest costs. Of
course, the worst-case scenario would be having trouble meeting operating and
debt liabilities during periods of adverse economic conditions.
Lastly, a company in a highly-competitive business, if hobbled by high debt,
may find its competitors taking advantage of its problems to grab more market share.
Unfortunately, there is no magic proportion of debt that a company can
take on. The debt-equity relationship varies according to industries involved,
a company's line of business and its stage of development. However, because
investors are better off putting their money into companies with strong balance
sheets, common sense tells us that these companies should have, generally
speaking, lower debt and higher equity levels.
Capital Ratios and
Indicators
In general, analysts use three ratios to assess the financial strength
of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios,
are popular measurements; however, it's the capitalization ratio that delivers
the key insights to evaluating a company's capital position.
The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and,
therefore, indicates a more leveraged position. The problem with this
measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied
to the debt/equity ratio, which compares total liabilities to total
shareholders' equity. Current and non-current operational liabilities,
particularly the latter, represent obligations that will be with the company
forever. Also, unlike debt, there are no fixed payments of principal or
interest attached to operational liabilities.
The capitalization ratio (total debt/total capitalization) compares the
debt component of a company's capital structure (the sum of obligations
categorized as debt + total shareholders' equity) to the equity component.
Expressed as a percentage, a low number is indicative of a healthy equity
cushion, which is always more desirable than a high percentage of debt.
Additional
Evaluative Debt-Equity Considerations
Companies in an aggressive acquisition mode can rack up a large amount
of purchased goodwill in their balance
sheets. Investors need to be alert to the impact of intangibles on the equity component of a company's capitalization. A material amount of intangible assets need to be considered carefully for its potential
negative effect as a deduction (or impairment) of equity, which, as a consequence, will adversely
affect the capitalization ratio.
Funded debt is the technical term applied to the portion of a company's long-term
debt that is made up of bonds and other similar long-term, fixed-maturity types
of borrowings. No matter how problematic a company's financial condition may
be, the holders of these obligations cannot demand payment as long as the
company pays the interest on its funded debt. In contrast, bank debt is usually
subject to acceleration clauses and/or
covenants that allow the lender to call its loan.
From the investor's perspective, the greater the percentage of funded debt to
total debt disclosed in the debt note in the notes to financial statements, the better.
Funded debt gives a company more wiggle room.
Lastly, credit ratings are formal risk evaluations by credit-rating agencies – Moody's,
Standard & Poor's, Duff & Phelps and Fitch – of a company's ability to repay principal and interest on debt obligations, principally bonds and commercial paper.
Here again, this information should appear in the footnotes. Obviously,
investors should be glad to see high-quality rankings on the debt of companies
they are considering as investment opportunities – and be wary of the reverse.
The Bottom Line
A company's reasonable, proportional use of debt and equity to support
its assets is a key indicator of balance sheet strength. A healthy capital
structure that reflects a low level of debt and a corresponding high level of
equity is a very positive sign of investment quality.
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