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1、EvaluatingACompany'sCapitalStructureForstockinvestorsthatfavorcompanieswithgoodfundamentals,a"strong"balancesheetisanimportantconsiderationforinvestinginacompany'sstock.Thestrengthofacompany'balancesheetcanbeevaluatedbythreebroadcategoriesofinvestment-qualitymeasurements:workin
2、gcapitaladequacy,assetperformanceandcapitalstructure.Inthisarticle,we'lllookatevaluatingbalancesheetstrengthbasedonthecompositionofacompany'scapitalstructure.Acompany'scapitalization(nottobeconfusedwithmarketcapitalization)describesthecompositionofacompany'spermanentorlong-termcapita
3、l,whichconsistsofacombinationofdebtandequity.Ahealthyproportionofequitycapital,asopposedtodebtcapital,inacompany'scapitalstructureisanindicationoffinancialfitness.ClarifyingCapitalStructureRelatedTerminologyTheequitypartofthedebt-equityrelationshipistheeasiesttodefine.Inacompany'scapitalstru
4、cture,equityconsistsofacompany'scommonandpreferredstockplusretainedearnings,whicharesummedupintheshareholders'equityaccountonabalancesheet.Thisinvestedcapitalanddebt,generallyofthelong-termvariety,comprisesacompany'scapitalization,i.e.apermanenttypeoffundingtosupportacompany'sgrowtha
5、ndrelatedassets.Adiscussionofdebtislessstraightforward.Investmentliteratureoftenequatesacompany'sdebtwithitsliabilities.Investorsshouldunderstandthatthereisadifferencebetweenoperationalanddebtliabilities-itisthelatterthatformsthedebtcomponentofacompany'scapitalization-butthat'snottheendo
6、fthedebtstory.Amongfinancialanalystsandinvestmentresearchservices,thereisnouniversalagreementastowhatconstitutesadebtliability.Formanyanalysts,thedebtcomponentinacompany'scapitalizationissimplyabalancesheet'slong-termdebt.Thisdefinitionistoosimplistic.Investorsshouldsticktoastricterinterpret
7、ationofdebtwherethedebtcomponentofacompany'scapitalizationshouldconsistofthefollowing:short-termborrowings(notespayable),thecurrentportionoflong-termdebt,long-termdebt,two-thirds(ruleofthumb)oftheprincipalamountofoperatingleasesandredeemablepreferredstock.Usingacomprehensivetotaldebtfigureisapru
8、dentanalyticaltoolforstockinvestors.It'sworthnotingherethatbothinternationalandU.S.financialaccountingstandardsboardsareproposingrulechangesthatwouldtreatoperatingleasesandpension"projected-benefits"asbalancesheetliabilities.Thenewproposedrulescertainlyalertinvestorstothetruenatureofth
9、eseoff-balancesheetobligationsthathavealltheearmarksofdebt.(Toreadmoreonliabilities,seeOff-Balance-SheetEntities:TheGood,TheBadAndTheUglyandUncoveringHiddenDebt.)Isthereanoptimaldebt-equityrelationship?Infinancialterms,debtisagoodexampleoftheproverbialtwo-edgedsword.Astuteuseofleverage(debt)increase
10、stheamountoffinancialresourcesavailabletoacompanyforgrowthandexpansion.Theassumptionisthatmanagementcanearnmoreonborrowedfundsthanitpaysininterestexpenseandfeesonthesefunds.However,assuccessfulasthisformulamayseem,itdoesrequirethatacompanymaintainasolidrecordofcomplyingwithitsvariousborrowingcommitm
11、ents.(Formorestoriesoncompanydebtloads,seeWhenCompaniesBorrowMoney,SpottingDisasterandDon'tGetBurnedbytheBurnRate.)Acompanyconsideredtoohighlyleveraged(toomuchdebtversusequity)mayfinditsfreedomofactionrestrictedbyitscreditorsand/ormayhaveitsprofitabilityhurtasaresultofpayinghighinterestcosts.Ofc
12、ourse,theworst-casescenariowouldbehavingtroublemeetingoperatinganddebtliabilitiesduringperiodsofadverseeconomicconditions.Lastly,acompanyinahighlycompetitivebusiness,ifhobbledbyhighdebt,mayfinditscompetitorstakingadvantageofitsproblemstograbmoremarketshare.Unfortunately,thereisnomagicproportionofdeb
13、tthatacompanycantakeon.Thedebt-equityrelationshipvariesaccordingtoindustriesinvolved,acompany'slineofbusinessanditsstageofdevelopment.However,becauseinvestorsarebetteroffputtingtheirmoneyintocompanieswithstrongbalancesheets,commonsensetellsusthatthesecompaniesshouldhave,generallyspeaking,lowerde
14、btandhigherequitylevels.CapitalRatiosandIndicatorsIngeneral,analystsusethreedifferentratiostoassessthefinancialstrengthofacompany'scapitalizationstructure.Thefirsttwo,theso-calleddebtanddebt/equityratios,arepopularmeasurements;however,it'sthecapitalizationratiothatdeliversthekeyinsightstoeva
15、luatingacompany'scapitalposition.Thedebtratiocomparestotalliabilitiestototalassets.Obviously,moreoftheformermeanslessequityand,therefore,indicatesamoreleveragedposition.Theproblemwiththismeasurementisthatitistoobroadinscope,which,asaconsequence,givesequalweighttooperationalanddebtliabilities.The
16、samecriticismcanbeappliedtothedebt/equityratio,whichcomparestotalliabilitiestototalshareholders'equity.Currentandnon-currentoperationalliabilities,particularlythelatter,representobligationsthatwillbewiththecompanyforever.Also,unlikedebt,therearenofixedpaymentsofprincipalorinterestattachedtoopera
17、tionalliabilities.Thecapitalizationratio(totaldebt/totalcapitalization)comparesthedebtcomponentofacompany'scapitalstructure(thesumofobligationscategorizedasdebt+totalshareholders'equity)totheequitycomponent.Expressedasapercentage,alownumberisindicativeofahealthyequitycushion,whichisalwaysmor
18、edesirablethanahighpercentageofdebt.(Tocontinuereadingaboutratios,seeDebtReckoning.)AdditionalEvaluativeDebt-EquityConsiderationsCompaniesinanaggressiveacquisitionmodecanrackupalargeamountofpurchasedgoodwillintheirbalancesheets.Investorsneedtobealerttotheimpactofintangiblesontheequitycomponentofacom
19、pany'scapitalization.Amaterialamountofintangibleassetsneedtobeconsideredcarefullyforitspotentialnegativeeffectasadeduction(orimpairment)ofequity,which,asaconsequence,willadverselyaffectthecapitalizationratio.(Formoreinsight,readCanYouCountOnGoodwill?andTheHiddenValueOfIntangibles.)Fundeddebtisth
20、etechnicaltermappliedtotheportionofacompany'slong-termdebtthatismadeupofbondsandothersimilarlong-term,fixed-maturitytypesofborrowings.Nomatterhowproblematicacompany'sfinancialconditionmaybe,theholdersoftheseobligationscannotdemandpaymentaslongthecompanypaystheinterestonitsfundeddebt.Incontra
21、st,bankdebtisusuallysubjecttoaccelerationclausesand/orcovenantsthatallowthelendertocallitsloan.Fromtheinvestor'sperspective,thegreaterthepercentageoffundeddebttototaldebtdisclosedinthedebtnoteinthenotestofinancialstatements,thebetter.Fundeddebtgivesacompanymorewiggleroom.(Toreadmoreonfinancialstatementfootnotes,seeFootnotes:StartReadingTheFinePrint.)Lastly,creditratingsareformalriskevaluationsbycredit-ratingagencies-Moody's,
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