CHAPTER
4Debt, Equity, Financial Structure, and the Investment Decision
T
raditionally the capital structure of a firm has been defined as the
book value of its common stock, its preferred stock, and its bonds, or
fixed liabilities. We discuss these balance sheet items in Chapter 2. The
equity and long-term debt items are considered to be the permanent fi-
nancing of the firm. A company that has only common shares in its capi-
tal structure is often described as conservatively or safely financed. But
if, for example, the firm has considerable trade debt outstanding, owes
on a bank loan, or is tied up with long-run rental contracts, it may not
be safely financed.
Although distinguishing between current liabilities and longer-term fi-
nancing is convenient in some analyses, the degree of difference between
current and funded debt is often grossly exaggerated. The so-called per-
manent financing is not unalterable; bonds can be retired, reduced, or in-
creased; so can preferred stock; and the book value of the total common
stock equity may also be varied. However, no operating firm is likely to
function without some amount of current liabilities; thus some current
debt is permanent to the financial structure. Perhaps it would be better to
consider a firm’s capital or financial structure as consisting of all the items
on the credit side of the balance sheet representing the equity and all the
liability accounts.
An important general tool of financial structure analysis is, then, the
ratio of total debt to total assets. Of course, in a detailed financial analysis,
the relationships and ratios among the items on the credit side of the bal-
ance sheet and among liability groupings and certain assets are significant
and useful; but sometimes the usual financing analysis may be misleading,
when only the fixed debt is employed in depicting the capital structure of
the firm.