July 02 2012| For stock investors that favor companies with good fundamentals, a "strong" balance sheet is an important

consideration for investing in a company's stock. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this article, we'll look at evaluating balance sheet strength based on the composition of a company's capital structure. A company's capitalization (not to be confused with market capitalization) describes the composition of a company's permanent or long-term capital, which consists of a combination of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness.

Clarifying Capital Structure Related Terminology The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization, i.e. a permanent type of funding to support a company's growth and related assets.

Is There an Optimal Debt-Equity Relationship? In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments.

A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result

of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share. Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development.

Capital Ratios and Indicators In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position. The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities. The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt. Additional Evaluative Debt-Equity Considerations

Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No

matter how problematic a company's financial condition may be, the holders of these obligations cannot demand payment as long the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded debt to total debt disclosed in the debt note in the notes to financial statements, the better. Funded debt gives a company more wiggle room. Lastly, credit ratings are formal risk evaluations by credit-rating agencies - Moody's, Standard & Poor's, Duff & Phelps and Fitch of a company's ability to repay principal and interest on debt obligations, principally bonds and commercial paper. Here again, this information should appear in the footnotes. Obviously, investors should be glad to see highquality rankings on the debt of companies they are considering as investment opportunities and be wary of the reverse. The Bottom Line A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of investment quality.