A company’s financial health is indicated by the balance sheet, and can be evaluated by 3 broad categories:
- Working Capital
- Asset Performance, and
- Capital Structure
Capital structure depicts a company’s debt and equity mix. A healthy proportion of equity and debt represents a healthy capital structure. Equity capital consists of Preferred Stock, Common Stock and Retained Earnings, which are summed up to form ‘Total Shareholder’s Equity’ in the Balance Sheet. Debt Capital generally comprises of short-term borrowings, long-term debt and current portion of the long-term debt. Equity capital is always costlier than the debt capital because the company shares its profit with the investors. The debt capital burdens the company with periodic interest payments, but the owners earn a tax rebate on the interest, with no profit sharing with the debt holders. But a highly leverage company can become a watchdog since the investors put restrictions to its activities. During economic downturn, if a competitive business is not able generate enough cash flows from its operations, it might have to file Chapter 11 Bankruptcy.
There is no magical debt levels defined. A company debt-to-equity ratio varies according to its stage of development, industry it operates in, and the lines of businesses it has. Analyst use various debt measuring ratios (debt-equity ratio, leverage ratio, EBITDA/interest, liquidity ratio, solvency ratio, to name a few) to analyze the financial health of the company. Various credit rating companies (like S&P, Moody’s, Fitch) evaluate a company’s ability to repay the principal along with the interest on debt obligations before awarding any rating. Capital Structure affects EPS (earnings per share) depending on whether it’s simple or complex. If the company has dilutive securities (complex capital structure), its diluted EPS is lower than the basic EPS; if it’s simple, then basic EPS equals diluted EPS.
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