Evaluating a Company’s Health: Equity vs Debt

Editor’s note: Mint.com has partnered with Minyanville.com to provide you with educational stories on the basics of investing. This is the second article in the series. The first one was Stock: Exactly What Is It?

Every corporation listed on U.S. stock exchanges has to pay for its operations in one of two ways: equity and debt.

The two sources together are called total capitalization. Money is raised to pay current expenses (salaries, utilities, taxes, advertising, etc.) as well as to invest in long-term assets (equipment, trucks, real estate, etc.).

Corporations often are distinguished by the dollar value of their equity capitalization. That is the number of shares of common stock outstanding, multiplied by the company’s current price per share.

For example, if a company has 80 million common shares outstanding and its current price for share is $30, its equity capitalization is $2.4 billion. Companies with over $10 billion in equity capitalization are called large cap (or big cap) companies. Those with equity between $2 and $10 billion are mid cap companies; and those with equity between $300 million and $2 billion are called small cap companies.

These distinctions are important because some investment strategies are based on equity capitalization size, especially in comparing a company to competitors in the same sector. For example, a large cap corporation is likely to be able to out-compete others in expanding its market share, either by gaining new customers or acquiring smaller companies to remove them from the scene.

Equity capitalization, the well-known common shares of stock traded every day on the stock market, are only one part of the capitalization scene. The otherpart is called debt capitalization: money raised through long-term debt (obligations with more than one year to repay). These include various kinds of corporate bonds secured by company assets or issued without any security (debentures); and bonds, contractual obligations that are repaid when they mature and pay interest each year.

Stockholders invest in shares of stock to acquire equity positions. They earn dividends and hope that the price per share will rise so that eventually, those shares can be sold on the stock exchange at a profit. In comparison, debt-holders own “paper” notes or bo0nds and earn interest.

One of the most important tests and investor should perform is an analysis of the comparative size of debt to total capitalization of a company. The debt ratio tells you whether the level of debt is rising, falling, or remaining about the same. The higher the debt level, the higher the percentage of future profits will have to be paid out in interest — and the less earnings remain to fund operations and pay dividends.

The study of capitalization is often overlooked, but it reveals all that you need to know about how companies manage their cash flow, and whether they are becoming increasingly dependent on lenders (through the issuing of bonds or acquiring of notes).

A well-managed company shows a trend of steady or falling debt over time, and not rising debt. Analysts are known to use an old favorite, the current ratio (comparing current assets to current liabilities) to judge how well a corporation is managing its cash flow. Over the long term, an analysis of total capitalization and tracking of the debt ratio reveals much more about corporate health.

This article is provided by Minyanville.com.

Michael C. Thomsett is the author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes full time.