Fool's School Capital Structure

One thing to examine when you evaluate a company as a possible investment is its "capital structure." Capital structure reflects the components of the company's value and how it finances its operations. A firm's capital structure will typically reflect one or more of the following: cash, debt financing (borrowing from a bank or issuing bonds), and equity financing (selling a chunk of the company and/or issuing shares of stock).

To understand the concept better, consider some examples. Imagine a company financed completely through debt. If it's paying 7 percent interest on its debt, but is growing earnings at 12 percent yearly, its payments can be met and the financing is effective. The lower the interest rate and the greater the difference between it and the company's earnings growth rate, the better. If a company is carrying a lot of debt at high interest rates, but is growing slowly, that's a red flag. Fluctuating earnings can also be problematic, as interest payments may sometimes completely wipe out profit.

Next, imagine a company that raises needed money only by issuing more stock. This is an appealing option when the market is hopping. The firm's shares trade at steep prices and buyers are plentiful, so cash is easily generated. The downside to equity financing, though, is that the value of existing shareholders' stock is diluted every time new shares are issued. This is OK only if the moolah raised creates more value for the company than the value eroded by dilution. Eventually, many great companies grow so profitable that they can methodically buy back shares, driving up value for existing shareholders.

Finally, imagine a firm that is financing its operations completely on its own. This means that it is fueling its growth with the cash created from operations. The advantage of internally financed growth is that it forces a firm to plan and budget carefully as it creates value for the company's owners. The weakness is that it can be a slow, grueling process. Worse yet, competitors effectively issuing debt or stock can fund more rapid growth than this company.