Capital structure primer

When assessing a company as a potential investment, for best results, you should study its business deeply. Among other things, it’s good to understand its “capital structure.”

A company’s capital structure is how it finances its operations — using cash, debt financing ( borrowing from a bank; issuing bonds) and/or equity financing (selling a chunk of the company; issuing shares of stock).

Imagine that Scruffy’s Chicken Shack (ticker: BUKBUK) is financed mainly with debt, paying 5% in interest on its loans. If it’s reliably growing its earnings by about 10% annually, that debt seems manageable. The interest rates companies pay depend on their credit ratings: Healthy companies are offered low rates, and shakier ones are stuck with higher rates.

Alternatively, Scruffy’s might finance itself by issuing stock. This is an especially attractive option during bull markets, when its shares will likely trade at high levels, allowing it to get more money for each share issued. That’s great, but every time the company issues shares, it’s diluting the value of the shares that existed before. (This extreme example will show why: If you owned 15 of a company’s 100 existing shares, you’d own 15% of the company. But if it issued another 50 shares, your 15-share stake would shrink to 10% of those 150 shares.) Dilution is only OK if the money raised helps the company increase its market value enough to more than offset the drop in value for existing shareholders. When a company becomes cash-rich, it can buy back shares, reducing that share count and thereby rewarding shareholders.

Finally, Scruffy’s might opt to grow only by using cash generated from its operations. That can be less risky, but it can create slower growth. Remember, too, that many successful companies were unprofitable in their early years — cash isn’t always plentiful. And rivals using equity or debt financing might grow faster.

Companies often use a combination of debt, stock and cash financing. The debt-to- equity ratio, which divides total debt by shareholder equity, offers insight into how companies finance themselves.