Capitalization ratios are used in financial analysis. This ratios are measures that indicate level of debt in capital structure of a company. High level of capitalization ratios indicates higher risk of bankruptcy. However it also increases return on equity due to association between debt and tax level. The optimal capitalization ratios are dependent on company and industry. Investors should monitor rather trends than individual values.
The main capitalization ratios
The main capitalization ratios are:
- Debt-equity ratio - informs about the company's ability to pay its liabilities with equity.
- Long-term debt to capitalization - it shows what part of the long-term debt falls on equity.
- Total debt to capitalization - it is indicator similar to the above.
Debt-equity ratio (DER ) = total debt / shareholders' equity
- Total debt = all current liabilities + long-term debt
The debt to equity ratio shows how much the company depends on borrowed capital compared to its own capital. The higher the ratio, the greater the risk associated with the structure of capital.
Long-term debt to capitalization
Long term debt is measured by dividing long term debt by long term and shareholders' equity. It is a leverage ratio. The formula is:
Long-term debt ratio (LTD) = long-term debt / (long-term debt + shareholders' equity)
- Long-term debt - These are liabilities and loans with a repayment term exceeding one year.
Total debt to capitalization
Total debt to capitalization is very similar to the Long-term debt ratio, but instead of considering long-term debt, the proportion of all debt to equity is calculated. The formula is:
Total debt ratio (TD) = total debt / (total debt + shareholders' equity)
Usage capitalization ratios in a business risk
This indicators are often presented in the form of a coefficient or percentage. It is assumed that the greater the relationship between liabilities and equity capital of the company, the greater the risk, caused by excessive indebtedness of the company and difficulty in obtaining capital from outside .
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Author: Justyna Banowska