If you are a stock investor who likes companies with good fundamentals, then a strong balance sheet is important to consider when seeking investment opportunities. By using three broad types of measurements—working capital, asset performance, and capital structure—you may evaluate the strength of a company's balance sheet, and thus its investment quality. In this article, we focus on analyzing the balance sheet based on a company's capital structure.

A firm's judicious use of debt and equity is a key indicator of a strong balance sheet. A healthy capital structure that reflects a low level of debt and a high amount of equity is a positive sign of investment quality.

Clarifying Capital Structure Terminology

Capital structure

Capital Structure = Debt Obligations + Total Shareholder's Equity
Capital Structure Formula.  Investopedia

Capital structure describes the mix of a firm's long-term capital, which consists of a combination of debt and equity. Capital structure is a permanent type of funding that supports a company's growth and related assets. Expressed as a formula, capital structure equals debt obligations plus total shareholders' equity. You may hear capital structure also referred to as "capitalization structure," or just "capitalization"—do not confuse this with market capitalization, which is different.

Equity

The equity portion of the debt-equity relationship is easiest to define. In a capital structure, equity consists of a company's common and preferred stock plus retained earnings. This is considered invested capital and it appears in the shareholders' equity section of the balance sheet. Invested capital plus debt comprises capital structure.

Debt

A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. However, there is an important distinction between operational liabilities and debt liabilities, and it's the latter that forms the debt component of capital structure—but that's not the end of the debt story.

Investment research analysts do not agree about what constitutes a debt liability. Many analysts define the debt component of capital structure as a balance sheet's long-term debt. However, this definition is too simplistic. Rather, the debt portion of a capital structure should consist of: short-term borrowings (notes payable); the current portion of long-term debt; long-term debt; and two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. When analyzing a company's balance sheet, seasoned investors would be wise to use this comprehensive total debt figure.

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Optimal Capital Structure

Ratios Applied to Capital Structure

In general, analysts use three ratios to assess the strength of a company's capitalization structure. The first two are popular metrics: the debt ratio (total debt to total assets) and the debt-to-equity (D/E) ratio (total debt to total shareholders' equity). However, it is a third quota, the capitalization ratiolong-term debt divided by (long-term debt plus shareholders' equity)—that delivers key insights into a company's capital position.

With the debt ratio, more liabilities mean less equity and therefore indicate a more leveraged position. The problem with this measurement is that it is too broad in scope and gives equal weight to operational liabilities and debt liabilities. The same criticism applies to the debt-to-equity ratio. Current and non-current operational liabilities, especially the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

On the other hand, the capitalization ratio compares the debt component to the equity component of a company's capital structure; so, it presents a truer picture. Expressed as a percentage, a low number indicates a healthy equity cushion, which is always more desirable than a high percentage of debt.

Optimal Relationship Between Debt and Equity?

Unfortunately, there is no magic ratio of debt to equity to use as guidance. What defines a healthy blend of debt and equity varies according to the industries involved, line of business, and a firm's stage of development. However, because investors are better off putting their money into companies with strong balance sheets, it makes sense that the optimal balance generally should reflect lower levels of debt and higher levels of equity.

About Leverage

In finance, debt is a perfect example of the proverbial two-edged sword. Astute use of leverage (debt) is good. It increases the amount of financial resources available to a company for growth and expansion. With leverage, the assumption is that management can earn more on borrowed funds than what it would pay in interest expense and fees on these funds. However, to carry a large amount of debt successfully, a company must maintain a solid record of complying with its various borrowing commitments.

The problem with too much leverage

A company that is too highly leveraged—too much debt relative to equity—might find that eventually its creditors restrict its freedom of action; or it could experience diminished profitability as a result of paying steep interest costs. In addition, a firm could have trouble meeting its operating and debt liabilities during periods of adverse economic conditions. Or, if the business sector is extremely competitive, then competing companies could (and do) take advantage of debt-laden firms by swooping in to grab more market share. Of course, a worst-case scenario might be if a firm needed to declare bankruptcy.

Enter the credit-rating agencies

Fortunately, though, there are excellent resources that can help us determine if a company might be too highly leveraged—the credit-rating agencies Moody's, Standard & Poor's (S&P), Duff & Phelps, and Fitch. These entities conduct formal risk evaluations of a company's ability to repay principal and interest on debt obligations, primarily on bonds and commercial paper.

A company's credit ratings from these agencies should appear in the footnotes to its financial statements. So, as an investor, you should be happy to see high-quality rankings on the debt of companies that you're considering as investment opportunities—likewise, you should be wary if you see poor ratings on companies that you are considering.