DEFINITION of 'Capitalization Ratios'
Indicators that measure the proportion of debt in a company’s capital structure. Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio and total debt to capitalization ratio. The formula for each of these ratios is shown below.
- Debt-Equity ratio = Total Debt / Shareholders' Equity
- Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders’ Equity)
- Total Debt to Capitalization = Total Debt / (Total Debt + Shareholders' Equity)
While a high capitalization ratio can increase the return on equity because of the tax shield of debt, a higher proportion of debt increases the risk of bankruptcy for a company.
Also known as leverage ratios.
INVESTOPEDIA EXPLAINS 'Capitalization Ratios'
For example, consider a company with short-term debt of $5 million, long-term debt of $25 million and shareholders’ equity of $50 million. The company’s capitalization ratios would be computed as follows –
- Debt-Equity ratio = ($5 million + 25 million) / 50 million = 0.60 or 60%
- Long-term Debt to Capitalization = $25 million / ($25 million + $50 million) = 0.33 or 33%
- Total Debt to Capitalization = ($5 million + $25 million) / ($5 million + $25 million + $50 million) = 0.375 or 37.5%
The acceptable level of capitalization ratios for a company depends on the industry in which it operates. Companies in sectors such as utilities, pipelines and telecommunications – which are capital intensive and have predictable cash flows – will typically have capitalization ratios on the higher side. Conversely, companies with relatively few assets that can be pledged as collateral – in sectors like technology and retail – will have lower levels of debt and therefore lower capitalization ratios.
The acceptable level of debt for a company is dependent on its whether its cash flows are adequate to service such debt. The interest coverage ratio, another popular leverage ratio, measures the ratio of a company’s earnings before interest and taxes (EBIT) to its interest expense. A ratio of 2, for instance, indicates the company generates $2 for every dollar in interest expense.
As with all ratios, a company’s capitalization ratios should be tracked over time to identify if they are stable. They should also be compared with similar ratios of peer companies, to ascertain the company’s leverage position relative to its peers.
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