Debt Ratios: Capitalization Ratio
AAA
  1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio

Debt Ratios: Capitalization Ratio

By Richard Loth (Contact | Biography)

The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum of long-term debt liabilities and shareholders' equity) to support a company's operations and growth.

Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of the more meaningful of the "debt" ratios - it delivers the key insight into a company's use of leverage.

There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage of development. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicate investment quality.


Formula:


Components:


As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total long-term debt of $81.60 (balance sheet), and total long-term debt and shareholders' equity (i.e., its capitalization) of $4,764.40 (balance sheet). By dividing, the equation provides the company with a negligible percentage of leverage as measured by the capitalization ratio.

Variations:
None

Commentary:
A company's capitalization (not to be confused with its market capitalization) is the term used to describe the makeup of a company's permanent or long-term capital, which consists of both long-term debt and shareholders' equity. A low level of debt and a healthy proportion of equity in a company's capital structure is an indication of financial fitness.

Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. It assumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However successful this formula may seem, it does require a company to maintain a solid record of complying with its various borrowing commitments.

A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meeting operating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab more market share.

As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on the relationship of debt liabilities as a component of a company's total capital base, which is the capital raised by shareholders and lenders.

The examples of IBM and Merck will illustrate this important perspective for investors. As of FY 2005, IBM had a capitalization ratio of 32%, and Merck's was 22%. It is difficult to generalize on what a proper capitalization ratio should be, but, on average, it appears that an indicator on either side of 35% is fairly typical for larger companies. Obviously, Merck's low leverage is a significant balance sheet strength considering its ongoing struggle with product liability claims. Eagle Materials and Lincoln Electric have capitalization ratios (FY 2006 and FY 2005) of 30% and 20%, which most likely fall into the average and low ratio range, respectively. Zimmer Holdings' 2% capitalization ratio needs no further comment.

Debt Ratios: Interest Coverage Ratio

  1. Debt Ratios: Introduction
  2. Debt Ratios: Overview Of Debt
  3. Debt Ratios: The Debt Ratio
  4. Debt Ratios: Debt-Equity Ratio
  5. Debt Ratios: Capitalization Ratio
  6. Debt Ratios: Interest Coverage Ratio
  7. Debt Ratios: Cash Flow To Debt Ratio
RELATED TERMS
  1. Non-Assessable Policy

    A type of insurance policy that cannot require the policyholder ...
  2. Development To Policyholder Surplus

    The ratio of an insurer’s loss reserve development to its policyholders’ ...
  3. Earned Premium

    The amount of total premiums collected by an insurance company ...
  4. Net Premiums Written To Policyholder Surplus

    A ratio of an insurance company’s gross premiums written less ...
  5. Net Liabilities To Policyholders' Surplus

    The ratio of an insurer’s liabilities, including unpaid claims, ...
  6. Reserves To Policyholders' Surplus Ratio

    The ratio of an insurer’s reserves set aside for unpaid losses ...
  1. What is a good debt ratio, and what is a bad debt ratio?

    Learn about the factors that influence how investors and lenders evaluate the debt ratio for a company and why the answer ...
  2. Are small cap companies more risky investments than large cap companies?

    Learn about the risk of small cap companies compared to large cap companies. Compare the volatility of both and learn how ...
  3. What main factors affect share prices in the metals and mining sector?

    Discover the primary factors that influence share prices of companies in the metals and mining sector and how companies can ...
  4. What does the efficient market hypothesis assume about fair value?

    Found out what the efficient market hypothesis says about the fair value of securities, and learn why technical and fundamental ...

You May Also Like

Related Tutorials
  1. Investing Basics

    Industry Handbook

  2. Bonds & Fixed Income

    Investing For Safety and Income Tutorial

  3. Fundamental Analysis

    Discounted Cash Flow Analysis

  4. Fundamental Analysis

    Ratio Analysis Tutorial

  5. Economics

    American Depositary Receipt Basics

Trading Center