The Motley Fool: Here’s a primer on company financing

One thing to examine when you evaluate a company as a possible investment is its “capital structure.” Capital structure reflects the components of the company’s value and how it finances its operations. A firm’s capital structure will typically reflect one or more of the following: cash, debt financing (borrowing from a bank or issuing bonds), and equity financing (selling a chunk of the company and/or issuing shares of stock).

To understand the concept better, consider some examples. Imagine a company financed completely through debt. If it’s paying 7 percent interest on its debt but is growing earnings at 12 percent yearly, its payments can be met and the financing is effective. The lower the interest rate and the greater the difference between it and the company’s earnings growth rate, the better. If a company is carrying a lot of debt at high interest rates but is growing slowly, that’s a red flag. Fluctuating earnings can also be problematic, as interest payments may sometimes completely wipe out profits.

Next, imagine a company that raises needed funds only by issuing more stock. This is an appealing option when the market is hopping. The firm’s shares trade at steep prices and buyers are plentiful, so cash is easily generated. The downside to equity financing, though, is that the value of existing shareholders’ stock is diluted every time new shares are issued. This is OK only if the moolah raised creates more value for the company than the value eroded by dilution. Eventually, many great companies grow so profitable that they can methodically buy back shares, driving up value for existing shareholders.

Finally, imagine a firm that’s financing its operations completely on its own. This means that it’s fueling its growth with the cash created from operations. The advantage of internally financed growth is that it forces a firm to plan and budget carefully as it creates value for the company’s owners. The weakness is that it can be a slow, grueling process. Worse yet, competitors effectively issuing debt or stock can fund more rapid growth than this company.

Ask the Fool

Q: When a company announces a stock split, there’s a “date of record.” If you buy shares after that date but before the split, do you get the additional shares? — R.T., Salinas, Calif.

A: Yes. The person who gets the benefit of the split shares is one who owns those shares on the day of the actual split, the pay date. As long as you’re holding the stock when it splits, you’ll get your due. The record date is mainly for accounting purposes.

My dumbest investment

This was both smart and dumb. In 1997 and 1999, I purchased a total of 875 shares of Cisco Systems for a total cost of $65,385. I ended up with 6,000 shares after several splits, and sold them in late 2000 for a tidy profit of $345,434. I traded in and out of the stock a few times after that, but I got burned in April 2001 when I sold 9,000 shares for a loss of $161,091. My net gain, after I closed out my position in late 2002, was $297,918, which reminds me of the saying, “Pigs get slaughtered.” — A.P., Menasha, Wis.

The Fool Responds: Overall, you were lucky to not be slaughtered too much. Frequent trading of a stock can be dangerous, as the market’s short-term movements are unpredictable. You might have bought into a great company destined to dominate its market, but over the next few months, it could swoon. It’s best to try to determine whether a stock is undervalued or overvalued, too. Undervalued stocks offer some margin of error. Overvalued stocks might sink to their rightful value.