Analyzing Company Capital Structures

Introduction

In this blog post, we'll look at how you can evaluate a company’s capital structure. A company’s capital structure is a critical aspect of long-term strategic and financial planning, so assessing it correctly can be the difference between success and failure. With the right understanding, you can use your assessments to inform sound decision-making when it comes to investments and private placements.

So, what is a capital structure? Simply put, it’s the composition of a company’s various financial sources—i.e., how it obtains and uses capital for its operations and investments. Generally, a business has two main sources for its capital: equity (e.g., stocks, LLC units, and other equities) and debt (e.g., loans and bonds). A company’s capital structure is what integrates these two sources to make the sum of its financial activity.

Factors to Consider When Analyzing a Company’s Capital Structure

Debt to Equity Ratios

Debt to equity ratios, also known as leverage ratios, are used to assess a company’s capital structure by measuring the amount of debt relative to the company’s equity. These ratios provide insight into the extent to which a company is using debt to finance its operations. If a company has a high debt to equity ratio, this indicates that a large portion of the company’s operations is being financed by borrowed money. On the other hand, a low debt to equity ratio indicates that a smaller portion of the company’s operations is being funded by debt. Investors should analyze a company’s debt to equity ratio to get an idea of the level of risk taken by the company and how well the company is managing its debt.

Interest Coverage Ratios

Interest coverage ratios measure the company’s ability to pay its interest payments on debt. This ratio measures the amount of the company’s earnings before interest and taxes (EBIT) relative to the amount of its interest payments. A high interest coverage ratio indicates that a company has sufficient earnings to comfortably make its interest payments, while a low interest coverage ratio indicates that the company may not be able to make its interest payments comfortably.

Leverage Ratios

Leverage ratios measure the extent to which a company is utilizing debt to finance its operations. The most commonly used leverage ratio is the debt-to-assets ratio, which measures the company’s debt relative to its total assets. A high debt-to-assets ratio indicates that the company is financing a large portion of its operations with debt, while a low ratio indicates that the company is using less debt. Other leverage ratios include the debt-to-equity ratio, the debt-to-capital ratio, and the long-term debt-to-equity ratio.

Operating Cash Flow

Operating cash flow measures the amount of money brought in by a company’s operations during a given period of time. This is an important indicator of a company’s ability to finance its operations. If a company’s operating cash flow is high, this indicates that the company is generating enough money to cover its expenses. On the other hand, if a company’s operating cash flow is low, this indicates that the company may not be able to cover its expenses. It is important to analyze a company’s operating cash flow in order to gain insight into the company’s ability to generate money to finance its operations.

3. How to Use a Capital Structure Analysis

A. Calculate Relevant Ratios

In order to assess a company’s capital structure, it is essential to calculate and analyze relevant ratios. Financial ratios provide a foundation for analysis as they serve as metrics for measuring the company’s performance against similar peers. This comparison can be used to assess capital structures and guide decision making. Relevant ratios to include in an analysis include:

• Debt to Equity Ratio
• Debt Ratio
• Interest Coverage Ratio
• Equity Multiplier
• Cash Ratio

B. Analyze Relevant Ratios

Once the relevant ratios have been calculated, they must be assessed. This involves comparing the ratios of the company being studied to the average values of similar companies. Therefore, it is important to identify a relevant peer group and gather data on the group. This comparison provides a baseline of understanding that can be used to determine the relative capital structure of the company.

C. Look for Added Insight

After a basic analysis has been performed, it is important to look for deeper insights into the company’s capital structure. For example, it is not enough to simply know that the company is highly leveraged, it is necessary to understand why. This can be done by examining the company’s decisions and actions over the past few years. Understanding the reasons behind changes in the capital structure can be helpful in making informed decisions.

Weighted Average Cost of Capital

Weighted Average Cost of Capital (WACC) is a tool used to measure and evaluate a company’s cost of capital. It takes into account both the cost of debt and equity, and is expressed as a percentage.

What it is

WACC is calculated by dividing the cost of capital by the amount of debt and equity. The cost of debt is the effective interest rate of the debt, while the cost of equity is the return that the stockholders require in order to invest in the company. WACC is useful in figuring out the minimum return that a company must attain in order to be profitable. To determine the WACC of a company, the weights of the debt and equity components must be taken into account. The weight of the debt component is determined by dividing the market value of debt by the total capital employed (debt plus equity). The weight of equity is calculated in the same manner, by dividing the market value of equity by the total capital employed.

Why it’s Relevant

WACC is an important consideration for assessing a company’s capital structure, as it can help to inform decisions such as whether to use debt or equity, how to raise capital and how to manage investments. It is often used as a benchmark for comparison when assessing whether a company’s return on its investments is in line with its cost of capital. WACC can also be used to compare a company’s cost of capital to its peers, allowing the company to identify areas where it could be more competitive.

WACC provides a useful metric for evaluating a company’s capital structure and its ability to attain profitability. While it’s difficult to make definitive statements about a company’s cost of capital based on its WACC, it can be a useful tool for assessing a company’s capital structure and identifying areas of potential improvement.

Calculating the Cost of Equity

The cost of equity is a complex and integral part of assessing a company’s capital structure. As such, it’s important to understand what components are needed to accurately determine the cost of equity. In this section, we'll look at the components needed, the risk-free rate, the market risk premium, and the company beta.

Components Needed

The components needed to calculate the cost of equity include the company’s expected dividend per share, the expected market return, the market risk premium, and the company-specific risk.

The expected dividend per share is calculated by taking the current dividend per share, added to the expected growth rate of the dividend, and then reducing the result by the inflation rate for the given period. This calculated number is then divided by the current price per share to determine the expected dividend.

The expected market return is based upon the return of a broad market index, such as the S&P 500. The market risk premium is calculated by subtracting the risk-free rate from the expected market return.

Lastly, the company-specific risk, or beta, is based on the volatility of the company's stock relative to an index, such as the S&P 500.

Risk-Free Rate

The risk-free rate is the interest rate that can be expected to be earned on a risk-free investment. This rate is typically determined by the current rate of return on long-term government bonds, such as 10-year treasury bonds.

Market Risk Premium

The market risk premium is calculated by taking the expected rate of return on the market index, minus the risk-free rate. This number helps to quantify the amount of risk associated with investing in a particular market index.

Company Beta

Companies have a specific level of risk associated with their stock. This risk can be measured in a variety of ways, but the most commonly used measure is the company's beta. Beta measures the movement of a stock relative to the movement of a broader index such as the S&P 500. A company with a beta of 1 will move approximately the same as the index, while a company with a higher beta is considered more risky.

Apply the Capital Structure Analysis

Understanding and assessing a company’s capital structure is an important and complex process. An analysis of the investment mix can help inform decisions regarding the composition of debt, preferred stock and equity financing. Information on the current ratio, debt-to-equity ratio and other financial measures can help give insights into the capital structure.

Balance of Financing

Financing a business requires a careful evaluation of the balance between debt and equity. The company’s ability to generate sufficient funds to pay back loans or meet the interests of other financing expenses should be considered in detail. In the ideal situation, the capital structure should match the nature of the business and provide the necessary support for growth and expansion.

Future Capital Needs

When assessing capital structure, one should not forget to plan for future capital needs. The company should assess the potential impacts of different financing methods. Assessing future cash flow needs, potential investments and other potential resource needs will provide some insight into the required capital structure.

Cost of Equity

The cost of equity should be taken into account when assessing capital structure. The cost of equity is the expected return on the company’s shares. This cost can vary significantly based on the company’s perceived risk profile and growth prospects.

• The company must assess if the cost of equity is lower or higher than the expected return from borrowing.
• The cost of equity should also be taken into account when considering the effects of any new equity issuance on the market price of the shares.

Conclusion

Assessing a company’s capital structure is a complex process that requires thorough research, analysis, and careful consideration of numerous factors. It is essential to gain an in-depth understanding of a company’s debt, equity and asset history in order to accurately assess their financial position. By assessing each of these variables, investors can get a comprehensive overview of the company’s risk/return profile and make educated decisions about potential investments.

A thorough analysis involves understanding the company’s debt-to-equity ratio and market capitalization, as well as factors such as the credibility of the company’s management team, their future growth prospects, strategic business investments, and more. Additionally, understanding the company’s dividend payment policy and using financial analysis tools such as financial statement analysis and cash-flow analysis can help provide a more complete picture of the company’s capital structure.

Overall Summary

Assessing a company’s capital structure is a complicated process requiring deep research, analysis and consideration of various factors. It is important to gain an in-depth understanding of the business’ debt, equity and asset history to evaluate their financial capacities. Evaluating each of these elements can paint a holistic picture of the business’ risk/return profile and inspire confidence in potential investments.

Final Thoughts

When evaluating the capital structure of any company, it is essential to use an approach that includes both technical and fundamental analysis. This will help to ensure that all of the necessary factors are weighed and that any potential mistakes are identified and addressed. Ultimately, the goal of such an analysis is to get a clear view of the company’s financial standing and ensure that any new investments are as low-risk and profitable as possible.