Structuring optimal Equity-Debt capital structure

By Odhiambo Ocholla

A capital structure is the mix of a company’s financing which used to fund its day-to-day operations. These sources of funds originate from equity, debt and hybrid securities.

The equity will come in the form of common and preferred stocks.

The debt is broken out into long-term and short-term debts. Hybrid securities are a group of securities that are a combination of debt and equity.

When analysing a company, it is important to note their mix of debt and equity, because it gives a firm picture of the financial health of the company. The higher the firm’s debt-to-equity ratio, the greater the risk of a potential investment.

For stock investors that favour 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.

Financial fitness

A company’s capitalisation 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. 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.

Among financial analysts, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company’s capitalisation is simply a balance sheet’s long-term debt, which should not be the case. Investors should stick to a stricter interpretation of debt where the debt component of a company’s capitalisation should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, and redeemable preferred stock.

Using a comprehensive total debt figure is a prudent analytical tool for stock investors. 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 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. Company considered too highly leveraged may find its freedom of action restricted by its creditors or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be failing to meet operating and debt liabilities during periods of adverse economic conditions.

Magic mix

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 safer putting their money into firms with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.

The balance sheet is an important consideration for investing in a company’s stock because it is a reflection of what the company owns and owes. 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 capitalisation structure.

In general, analysts use three different ratios to assess the financial strength of a company’s capitalisation structure.

The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it’s the capitalisation ratio that delivers the key insights to evaluating a company’s capital position. The debt ratio compares total liabilities to total assets.

This measurement is, however, too broad, which in effect 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.

—The writer (nyabolla@gmail.com) is an Investment Banker.