Capital
Structure Analysis
In
addition to assessing a firm’s ability to meet its short-term obligà lion, it Is
impOrtaflt to evaluate its ability to pay long-term debts as they mature. This
requires comparmg the amount oflong-term obligations andthe company’s ability
to generate cash in the long term. This ability is greatly affected by the
amount of long-term debt the company has in relation to equity.
Capital structure is the mix of long-term debt, on which interest and
principal payments must be made, and equity, in the form of common and
preferred stock, which the firm uses to finance operations. The capital
structure affects both the risk and returns of the firm and is directly related
to leverage.
Financial leverage is the use of debt (fixed cost funds) to increase returns
to owners (stoctholders). Debt that is too low may result in a company not
being able to take full advantage of opportunities. Debt that is to? high may
affect the company’s ability to weather difficult economic times and continue
to pay its obligations as debt or mterest payments come due. There is no
standard guideline or optimal leverage number; this varies by industry and
firm.
Firms have
a mix of debt and equity fmancing. Debtholders, including fmancial institutions
and corporate bond investors, are often, but not always, promised a return
based on the stated interest rate for the debt. There are costs associated with
issuing debt and equity. (Debt is usually cheaper but will increase as the
firm’s ratio of debt to equity increases). Most companies maintain a balance of
debt and equity based on the cost of capital for each and the level of risk
they wish to maintain.
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