Capitalization ratio compares total amount of debt to capital structure(capitalization). It indicates proportion of any company dept. This ratio shows us the scope of company own capital to the their credits. Capitalization ratio is sometimes called as financial leverage ratio. Or in short version simply as cap ratio. Investors can find out about the extent to which the company uses their capital to support their business and growth. It also helps in risk assessment. When company has high capitalization ratio it is qualified as risky to be invest in or to cooperate with them because they might be insolvent or bankrupt due to their high loans which they must pay off first. Also banks pay a lot of attention to capitalization ratio. With high capitalization ratio it is much harder to get another loan in the future. From company point of view, equity is considered much safer than debt.
On the other hand, high proportion is not always as bad as it seems to be. Higher financial leverage can improve a shareholders profit because those company may count on tax advantages, allowances associated with the loan. Generally speaking it is a financial metric of company solvency where total debt is compared to total equity.
There are two main components important to calculating capitalization ratio. They are debt and equity as mentioned above.
Formula for calculating each ratio looks like this:
- debt equity ratio = total debt / shareholders equity
- long term debt ratio = tong term debt / (long term debt + shareholders equity)
- total debt ratio = total debt / (total debt + shareholders equity)
Long term debt - loans lasting more than one year.
Total debt is sum of long-term and short-term loans of company
Shareholder's equity is sum of investment made by each investor
Debt-equity can be calculated by dividing those to values Capitalization ratio is calculated by dividing debt by total equity in given formula.
Examples of each ratio:
- (2 million + 15 million) / 30 million = 0,56 or 56%
- 15 million / (15 million + 30 million) = 0.33 or 33%
- ( 2 million + 15 million) / (2 million + 15 million + 30 million) = 0,361 or 36.1%
Thanks to those calculations cap ratio is very meaningfull when it goes to getting insight the use of financial leverage by a company. It focuses relations related with long term debt with total capital. This total capital is not only company capital but it is a capital raised by lenders and shareholders as well.
Generally, if financial leverage ratio is not bigger that 0.5 than this company can be considered as financial healthy. But looking forward, this ratio must be compared with other company from given compartment. For example, companies that must have a large amount of specialized equipment, physical assets(utility companies) which allows them to do their job have higher debt compared to equity.
Examples of Capitalization ratio
- Debt to Equity Ratio: This ratio is used to measure the capital structure of a company. It is calculated by dividing total debt (long-term liabilities) by total equity. A high Debt to Equity ratio indicates a high level of leverage and a low level of equity.
- Debt to Asset Ratio: This ratio is used to measure the amount of debt a company has relative to its total assets. It is calculated by dividing total debt by total assets. A high Debt to Asset ratio indicates a high level of leverage and a low level of equity.
- Interest Coverage Ratio: This ratio is used to measure a company’s ability to meet its interest payments. It is calculated by dividing earnings before interest and taxes (EBIT) by interest expense. A low Interest Coverage Ratio indicates a company is having difficulty meeting its debt obligations.
- Cash Flow to Debt Ratio: This ratio is used to measure a company’s ability to pay off its debt. It is calculated by dividing operating cash flow by total debt. A high Cash Flow to Debt Ratio indicates a company is in a strong position to pay off its debt.
Advantages of Capitalization ratio
Capitalization ratio is an important measure of a company's financial strength and stability. It provides an indication of the relative proportion of debt and equity used to finance a company's operations and activities. The following are some of the advantages of using the capitalization ratio:
- It offers insight into a company's ability to meet its financial obligations. A high capitalization ratio indicates that the company is more likely to be able to meet its debt obligations.
- It allows investors to assess the risk associated with investing in a particular company. Companies with higher capitalization ratios are generally viewed as more financially sound and less risky investments.
- It also helps lenders and creditors decide if they should extend credit to a company. Companies with higher capitalization ratios are more likely to be viewed as creditworthy.
- It provides a quick and easy way to compare the capital structure of different companies. Investors can use the capitalization ratio to compare companies in the same industry and see which ones have the most favorable capital structures.
Limitations of Capitalization ratio
Capitalization ratio has its limitations. The following are some of the limitations of capitalization ratio:
- It does not accurately reflect the risk involved in the capital structure of the company. The ratio does not take into account the quality of the debt and equity that the company has.
- It does not account for the liquidity of the firm’s assets and liabilities. It does not provide any indication as to whether the company is able to meet its financial obligations.
- It does not take into account the tax implications of a particular capital structure. The ratio does not factor in the tax benefits or costs associated with different capital structures.
- It does not account for the potential changes in the market value of a company’s assets and liabilities. It does not provide an indication of how the company’s stock price or debt-equity ratio may be affected by changes in the market.
- The ratio does not factor in the current economic conditions or the company’s industry. It does not provide an indication of how the company’s capital structure may be impacted by changes in the macroeconomic environment.
One of the most common approaches related to Capitalization ratio is the Debt to Equity Ratio. This ratio is used to evaluate the extent to which a company finances its operations and growth through debt versus its own equity. Other approaches include:
- Interest Coverage Ratio: This ratio is used to assess a company's ability to cover interest payments on its debts and is calculated by dividing the company's operating income by its interest expenses.
- Debt to Assets Ratio: This ratio measures the percentage of a company's total assets that are financed by debt, and is calculated by dividing a company's total debt by its total assets.
- Debt to Cash Flow Ratio: This ratio is calculated by dividing a company's total debt by its cash flow. It is a measure of a company's ability to pay off its debt obligations with its available cash flow.
In summary, there are several approaches related to Capitalization ratio that can be used to evaluate a company's financial performance, including the Debt to Equity Ratio, Interest Coverage Ratio, Debt to Assets Ratio, and Debt to Cash Flow Ratio.
- Jacque L., 2001, page 137
- Jacque L., 2001, page 137
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- Jacque L. (2001). Financial Innovations and the Welfare of Nations, Walter de Bruyter Inc, Boston, page 137
- Laeven. L., Blouin J., Huizinga H., Nicodème J.A. (2014). Thin Capitalization Rules and Multinational Firm Capital Structure, page 8
- Lessambo F. (2018). Auditing, Assurance Services, and Forensics: A Comprehensive Approach, Palgrave macmillan, New Britain, page 384
- Thomsett C. (2018). Math for Managers, Walter de Bruyter Inc, Boston, page 90
Author: Magdalena Wójcik