Capitalization ratio

Capitalization ratio
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Methods and techniques

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[1]. 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[2].

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.

Main Components[edit]

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)

where:

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%

Usage[edit]

Thanks to those calculations cap ratio is very meaningfull when it goes to geting insight the use of financial leverage by a company[3]. 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.

Footnotes[edit]

  1. Jacque L., 2001, page 137
  2. Jacque L., 2001, page 137
  3. Blouin J., Huizinga H., Laeven. L., Nicodème J.A. ,2014, page 8

References[edit]

Author: Magdalena Wójcik