How to Analyze Capital Structure

Analyzing capital structure is a good way to assess risk on your terms. Investment analysts use balance sheet analysis to determine both the current health of a business as well as its likelihood for growth. You can determine the same ratios and observations to give yourself a clear idea of how a company is capitalized.

The balance sheet is a snapshot of what a company owns and owes at a point in time. A company's assets are matched to its liabilities, with the difference referred to as owner's or shareholders' equity. This may be expressed in dollar values or expressed as a percentage of total assets, called a common-size balance sheet. This allows comparison of companies of different size or to see how a company stacks up against industry averages.

A company with a wealth of assets still pays its bills from month to month. Calculating working capital indicates how well a company can do this. Expressed in dollars, you subtract current liabilities, such as loan payments, payroll and rent, from current assets, such as cash accounts, inventory and receivables. The surplus is the amount of working capital a company has for investment in other parts of the business, such as advertising or research. When current assets and liabilities are equal, there is no working capital, and a negative result may indicate serious cash flow issues.

The current ratio is an expression of working capital in a form that compares against industry averages or other companies of different size. Current ratio divides current assets by current liabilities. For example, Company A, with $98,000 of current assets and $70,000 in current liabilities, has working capital of $28,000 and a current ratio of 1.4. Company B, with $200,000 and $160,000 in current assets and liabilities has, at $40,000, more working capital, but a ratio of 1.25, which means Company B has less working capital available as a proportion of its assets.

The quick ratio is a measure of how a company can perform financially in a crisis. Assets for this ratio exclude inventory, supplies and prepaid expenses, focusing only on assets that can be turned into cash quickly, such as bank accounts and receivables. If Company A in the previous example has only $64,000 in current assets easily convertible to cash, its quick ratio is 0.91:1. This is determined by dividing the convertible assets by current liabilities and expressing it as a ratio.

For an investor, debt may represent risk, even though some debt may fund business growth beyond what a company's cash could support. Cash-to-debt divides current assets by total short- and long-term debts. The value of this ratio varies by investor and risk comfort levels. Debt-to-equity divides long-term debt by owner's equity. With this ratio, the current number may not be as significant as changes to that number over time. Since a balance sheet is a moment in time, all capital structure analysis benefits from comparing a company's balance sheets over a period of a few years, noting trends and changes.