Capitalization ratios

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.

Capitalization ratios are referred to as the leverage ratio. When a company is developing itself, borrowing leverage indicators measure the company's ability to repay the debt.

Debt-equity ratio

Debt equity ratio is measure an capital's structure. This ratio is calculated by dividing the total debts of the enterprise by shareholders' equity. The formula is:

Debt-equity ratio (DER ) = total debt / shareholders' equity

Where:

• 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)

Where:

• 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 .

Examples of Capitalization ratios

• Debt-to-Equity Ratio: Debt-to-equity ratio is a measure of the company’s financial leverage calculated by dividing its total liabilities by total shareholders’ equity. It indicates how much debt a company is using to finance its assets relative to the amount of equity. For example, if a company has total liabilities of $50 million and total equity of $20 million, then its debt-to-equity ratio is 2.5.
• Interest Coverage Ratio: Interest coverage ratio is a measure of a company’s ability to pay the interest on its debt. It is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expenses. For example, if a company has EBIT of $10 million and interest expenses of $2 million, then its interest coverage ratio is 5.
• Equity Multiplier: Equity Multiplier is a measure of financial leverage calculated by dividing total assets of the company by total equity. It indicates how much total assets a company has for each dollar of shareholders’ equity. For example, if a company has total assets of $200 million and total equity of $50 million, then its equity multiplier is 4.

Advantages of Capitalization ratios

Capitalization ratios provide an effective tool for financial analysis, allowing investors to assess the debt level of a company and its associated risks. The following are some of the advantages of capitalization ratios:

• They allow investors to quickly identify companies with high debt levels and associated higher risks of bankruptcy.
• They provide insight into the company's ability to cover its debt obligations from its current operations.
• They allow investors to compare the capital structure of a company to those of its competitors, providing a measure of competitive advantage.
• They help investors to identify companies with high potential for return on equity due to their high debt levels and associated tax benefits.

Limitations of Capitalization ratios

Capitalization ratios have some limitations which should be taken into account when using them for financial analysis. These include:

• The ratio does not take into account the quality of the debt or equity. It does not provide information about the creditworthiness of the company or the overall risk associated with the debt.
• The ratio does not provide information about the liquidity of a company. It does not measure the ability of a company to pay its short-term debt.
• The ratio does not measure the profitability of the company. It does not provide any information about the company's ability to generate returns on its investments.
• Capitalization ratios do not take into account the effects of inflation or changes in interest rates. This can lead to inaccurate results when trying to compare companies over different time periods.

Other approaches related to Capitalization ratios

In addition to capitalization ratios, there are other approaches to financial analysis which provide insights into the overall financial health of a company. These include:

• Free Cash Flow – This measures the amount of cash a company generates after accounting for capital expenditures. It indicates the company's ability to generate cash to pay debt, pay dividends, and fund operations.
• Quick Ratio – This is a measure of a company's liquidity. It indicates the company's ability to meet its short-term obligations with its most liquid current assets.
• Debt to Equity Ratio – This is a measure of a company's leverage, which indicates how much of its capital structure is composed of debt.
• Return on Equity – This is a measure of a company's profitability. It shows how efficiently a company is utilizing its equity to generate profits.

In conclusion, capitalization ratios are just one tool used in financial analysis. Other approaches such as free cash flow, quick ratio, debt to equity ratio, and return on equity can also provide valuable insights into the financial health of a company.

Capitalization ratios — recommended articles

Debt to total assets ratio — Debt management ratio — Capitalization ratio — Coverage ratio — Solvency ratios — Asset equity ratio — Cash Flow-to-Debt Ratio — Degree of financial leverage — Fixed-Charge Coverage Ratio

References

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• Faccio M., Lang L. H., Young L. (2001). Dividends and expropriation. American Economic Review, 91(1), 54-78
• Heikal M., Khaddafi M., Ummah A. (2014). Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia Stock Exchange., "International Journal of Academic Research in Business and Social Sciences", No. 4(12), p 101- 114
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• Nawaz A., Ali R., Naseem M. A. (2011). Relationship between capital structure and firms performance: a case of Textile sector in Pakistan., "Global Business and Management Research", No. 3(3/4), p. 270
• Salim M., Yadav R. (2012). Capital structure and firm performance: Evidence from Malaysian listed companies., "Procedia-Social and Behavioral Sciences", No. 65, p. 156-166

Footnotes

Author: Justyna Banowska