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Capital Structure

by Noah Howell

Understanding a company’s capital structure is critical to determining how it finances its operations.

When it comes to funding operations and long-term expansion, a company’s capital structure consists of a combination of debt and equity. In most cases, debt is made up of bonds and loans, while equity is typically made up of shares of stock and preferred stock. It is through the capital structure that the company’s overall financial strategy is laid out. In the process of distributing the company’s profits, it can show which securities (bonds or stocks) take precedence and which fall further down the priority list. Investors who are most likely to benefit from a reorganisation can also be identified.

Equity and debt are the two pillars of a company’s capital structure. Trade-offs between increasing debt and issuing equity to fund operations are made by companies. In order to gauge a company’s level of risk, you can look at the debt-to-equity ratio (also known as the use of leverage). For the most part, companies that are heavily indebted and rely on debt to fund their operations are considered to have a more risky capital structure (or high leverage).

There are various types of shares available for purchase by the company, as well as bonds and notes that the company issues in order to raise money. It’s possible to have ordinary or preferred shares. Preferred stock, on the other hand, gives shareholders a higher priority in receiving dividends from the company.

As opposed to this, there are various types of bonds: senior, second-lien, or any combination of these. For investors, cash or assets that are pledged as collateral have a priority right to be repaid in the event of default. However, unsecured debt can only be repaid with money that has not yet been spent. Generally speaking, when it comes to making interest payments, senior debt takes precedence over secondary debt.

Investing requires a thorough understanding of a company’s stock and bond prices and the resulting capital structure. Fidelity’s equity analysts examine the company’s stock, while its fixed income analysts analyse its bonds in order to determine its capital structure. The importance of both perspectives cannot be overstated. In fact, because stockholders and bondholders who invest in a company have different motivations, the company can tailor its message to appeal to either group.

Some companies will insist on their expansion plans and the necessity of debt financing to increase production, or on stock buybacks or future dividend payments, when they approach a shareholder. This outlook may be appealing to stockholders, but bondholders will be put off by the higher default risk. However, a company could paint a very favourable picture of its credit by insisting on the strict management of its balance sheet or the repayment of its debt – arguments that are less convincing to the holders of stock.

As a result, Fidelity has both equity and fixed income divisions that monitor and analyse companies around the world, and they share their findings.

Fidelity’s analysts don’t look at equity and credit in isolation; they attend company presentations for both bondholders and shareholders to get a complete picture. The fact that we are not limited to one type of investment gives us an edge over our competitors. Fidelity is able to make well-informed decisions for investors because of our comprehensive understanding of a company’s capital structure.

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