A major factor in determining financial health is the company's underlying capital structure.
What is the best way to capitalize a company? Is it equity or debt? The answer is that it depends, as both debt and equity have their advantages.
Debt offers the following advantages.
1. Lenders have no direct claim on future earnings. Debt can be issued without worries about a claim on earnings. As long as the interest is paid, the company is fine.
2. Interest paid on debt can be deducted for tax purposes.
3. Most payments, whether they are interest or principal payments, are usually predictable, and so a company can plan ahead and budget for them.
4. Debt does not dilute the owner's interest, and so an owner can issue debt and not worry about a reduced equity stake.
5. Interest rates are usually lower than the expected return. If they are not, a change in management can be expected soon.
Debt securities can take a number of different forms, the most common being bonds.
Bonds are obligations secured by a mortgage on company property
Bonds tend to be safer from the investors' standpoint and therefore pay lower interest.
Debentures, in contrast, are unsecured and are issued on the strength of the company's reputation, projected earnings, or growth potential.
Debentures, being far riskier, tend to pay more interest than do their more secure counterparts.
Equity has the following advantages:
1. Equity does not raise a company's break-even point. A company can issue equity and not have to worry about achieving performance benchmarks to fund the equity.
2. Equity does not increase the risk of insolvency, and so a company can issue equity and not have to worry about any subsequent payments to service that equity. Equity is essentially capital with unlimited life and so a company can issue equity and not have to worry about when it comes due.
3. There is no need to pledge assets or offer by personal guarantees when equity is issued.
Equity can take a number of different forms.
A simple form of equity is common stock.
This type of stock offers no limits on the rate of return and can continue to rise in price indefinitely.
There are no fixed terms; the stock is issued and the holder bears the stock.
Preferred stock entitles the holders to receive dividends at a fixed or adjustable rate of return and ranks higher than common stock in a liquidation.
Preferred stock may have anti-dilution rights so that in a subsequent stock offering, preferred stockholders may maintain the same equity stake.
Convertible securities are highly structured in nature and are based on certain parameters. As the word convertible indicates, they may convert into other securities.
Among the most common are warrants and options.
Warrants and options stand for the right to buy a stated number of shares of common or preferred stock at a specified time for a specified price.
There are also convertible notes and preferred stock, which refer to the right to convert these notes to some common stock when the conversion price is more favourable than the current rate of return.