Capital structure analysis is a periodic evaluation of all components of the debt and equity financing used by a business. The intent of the analysis is to evaluate what combination of debt and equity the business should have. This mix varies over time based on the costs of debt and equity and the risks to which a business is subjected. Capital structure analysis is usually confined to short-term debt, leases, long-term debt, preferred stock, and common stock. The analysis may be on a regularly scheduled basis, or it could be triggered by one of the following events:
- The upcoming maturity of a debt instrument, which may need to be replaced or paid off
- The need to find funding for the acquisition of a fixed asset
- The need to fund an acquisition
- A demand by a key investor to have the business buy back shares
- A demand by investors for a larger dividend
- An expected change in the market interest rate
When engaging in a capital structure analysis, consider the following questions:
- How does the current or projected capital structure impact any loan covenants, such as the debt to equity ratio? If the effect is negative, it may not be possible to acquire any additional debt, or existing debt may need to be paid down.
- Are there any expensive tranches of debt that can be paid down? This involves a discussion of alternative uses for any available cash, which could be more profitably employed elsewhere.
- Are the uses for cash within the company's business beginning to decline? If so, does it make more sense to return cash to investors by buying back shares or issuing more dividends?
- Are the company's financial circumstances so difficult that it will be more difficult to obtain loans in the future? If so, does it make sense to restructure operations to improve profitability and thereby reopen this financing alternative?
- Does the investor relations officer want to establish a floor for the company's stock price? This can be achieved by engaging in an ongoing stock repurchase program that is triggered whenever the stock price falls below a certain amount.
- Does the company want to achieve a certain rating for its bonds? If so, it may need to restructure its financing mix to be more conservative, thereby improving the odds of investors being repaid by the company for their purchases of the company's bonds.