Corporate finance

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' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In thisarticle, 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'scapital 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 anddebt, 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 thelatter 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. Investorsshould 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 analyticaltool 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 therean 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 formulamay 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 troublemeeting 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...