How to Distinguish Between Debt & Equity Capital
Corporations always need sufficient capital to pay operating expenses and to pursue new opportunities. When a company has insufficient retained earnings, it will look to raise capital by offering equity such as stock to new investors, or turn to debt financing from banks and other financial institutions. To evaluate a company’s balance sheet, you must analyze the breakdown between its debt and equity financing.
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Instructions
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Calculate the company’s total asset value. To have some context for the balance between the debt and equity capitalization of a company, first review the total assets the company reports on its balance sheet. The funds a company uses to purchase assets and pay expenses always comes from its debt or equity capital. As a result, the sum of a firm’s equity and debt financing will not exceed the total asset value.
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Review the liabilities section of the balance sheet for payable accounts. Payable accounts report the outstanding debts of a company. However, this can cover a wide range of liabilities, such as accounts payable, which reports debts to suppliers, service providers and all other short-term creditors. The liabilities section also reports long-term debts, such as the notes and bond payable account balances that reflect the outstanding debt the company owes to banks for loans and capital it borrows from the general public. These two accounts are likely to include most of a firm’s debt financing, because long-term debt obligations tend to be more substantial than the short-term obligations.
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Assess whether the company reports a retained earnings balance. The retained earnings account is one component of the equity section of the balance sheet. The balance of retained earnings reports the cumulative amount of net income the company earns over the year and is an amount from which it pays dividends to shareholders. However, any amount from the retained earnings balance that the company uses for operational expenses is a form of equity financing.
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Combine the balances in all stock and paid-in capital accounts. The other component of the equity section reports all contributions of capital by shareholders, which is also equity financing. Most balance sheets report the capital contributions from common and preferred shareholders at the stocks par value. You will also find “paid-in capital” accounts for both categories of shareholders to report the amount in excess of par that shareholders pay in exchange for the shares. Combining the paid-in capital and par value account balances provides the remaining source of equity capital to a corporation.
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Tips & Warnings
Investors and creditors who have an interest in the relationship between a company’s debt and equity financing often use the debt-equity ratio to perform a quick analysis of a company’s leverage. You calculate the ratio as total liabilities divided by total equity. Results greater than one indicate that the company obtains more capital from debt than it does from equity, which is generally undesirable to investors and creditors.
