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Capital Structure, Explained

By Motley Fool Staff – Updated Nov 16, 2016 at 12:58PM

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It's all about cash, debt, and equity.

When evaluating a company's merits as a possible investment, you should examine the components of its value and explore how it finances its workings. This is referred to as a company's "capital structure." It's usually a mix of 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).

A gander at some (admittedly extreme) examples will shed more light on the concept. Imagine a company financed completely through debt. If it's paying 5% interest on its debt but is growing earnings at 10% 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, this is bad news. Fluctuating earnings can also be problematic, as interest payments may sometimes completely wipe out earnings.

Next, imagine a company that raises needed funds only by issuing more stock. This is an appealing option when the market is hopping; cash is generated with little effort. It's not as easy or effective when the market is in the doldrums, though. The downside to equity financing is that the value of existing shareholders' stock is diluted every time new shares are issued. This is OK only if the moola raised creates more value for the company than the value eroded by dilution. Eventually, the company may become so profitable that it can methodically buy back shares, driving up value for existing shareholders. This is something that companies such as Inside Value recommendations Coca-Cola (NYSE:KO) and Microsoft (NASDAQ:MSFT), Stock Advisor pick Gap (NYSE:GPS), and others have done in the past.

Finally, imagine a company that's financing its operations completely on its own. This means that it's fueling growth with the cash created from operations. The advantage of internally financed growth is that it forces a company to plan and budget carefully, resulting in (sometimes gradual) value creation 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 growth more rapidly than this company.

That's it -- whatever combination of debt, equity, and cash financing a company uses is its capital structure.

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