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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT... More
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  • Equity And Debt, The Basics 0 comments
    Mar 30, 2014 10:32 AM

    Every corporation listed on U.S. stock exchanges has to pay for its operations in one of two ways: equity and debt.

    The two sources are total called total capitalization. Money is raised to pay current expenses (salaries, utilities, taxes, advertising, etc.) as well as to invest in long-term assets (equipment, trucks, real estate, etc.). Corporations often are distinguished by the dollar value of their equity capitalization. That is the number of shares of common stock outstanding, multiplied by the company's current price per share.

    For example, if a company has 80 million common shares outstanding and its current price for share is $30, its equity capitalization is $2.4 billion. Any company with over $10 billion in equity capitalization is call a large cap (or big cap) company. If the value is between $2 and $10 billion, the company is a mid cap company; and between $300 million and $2 billion is called small cap.

    These distinctions are important because some investment strategies are based on equity capitalization size, especially in comparing a company to competitors in the same sector. For example, a large cap corporation is likely to be able to out-compete others in expanding its market share, either by gaining new customers or acquiring smaller companies to remove them from the scene.

    Equity capitalization, the well-known common shares of stock traded every day on the stock market, are only one part of the capitalization scene. The other is debt capitalization, money raised through long-term debt (obligations with more than one year to repay). These include various kinds of corporate bonds secured by company assets or issued without any security (debentures); and bonds, contractual obligations that are repaid when they mature and pay interest each year.

    Stockholders invest in shares of stock to acquire equity positions. They earn dividends and hope that the price per share will rise so that eventually, those shares can be sold on the stock exchange at a profit. In comparison, debt-holders own "paper" notes or bo0nds and earn interest.

    One of the most important tests investor perform is an analysis of the comparative size of debt to total capitalization. The debt ratio tells you whether the level of debt is rising, falling, or remaining about the same. The higher the debt level, the higher the percentage of future profits will have to be paid out in interest - and the less earnings remain to fund operations and pay dividends.

    The study of capitalization is often overlooked, but it reveals all that you need to know about how companies manage their cash flow, and whether they are becoming increasing dependent on lenders (through issue of bonds or acquiring of notes). A well-managed company shows a trend of steady or falling debt over time, and not rising debt. Analysts are known to use an old favorite, the current ratio (comparing current assets to current liabilities) to judge how well a corporation is managing its cash flow. Over the long term, an analysis of total capitalization and tracking of the debt ratio reveals much more about corporate health.

    To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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