What Is Capitalization Change?
Capitalization change refers to a modification of a company's capital structure inclusive of equity and debt. A company's initial capitalization involves equity and perhaps some debt when there is a change to equity, or both components (if debt is part of the capital structure), a capitalization change results.
Understanding Capitalization Change
Generally, a company starts its life with capital contributed by the founder(s), family, and friends. As the company grows, it may seek funds from venture capital investors. Any new capital injected into the firm will lead to a capitalization change - simply, a greater amount of equity at this point. Suppose that this company progresses on a profitable path where cash flows and assets build. The company would then be in a position to seek bank loans or even issue debt. The addition of debt to the balance sheet would represent another capitalization change. As the company continues to mature, its financing needs become more sophisticated, calling for various adjustments, even transformations depending on the growth of the firm and the dynamics of the industry, to the capital structure. The issuance of new shares and assumption of debt for a large acquisition, for example, could fundamentally alter the capitalization of a company.
Responsible Capitalization Changes
A responsible company strives to balance the amount of equity and debt in its capital structure according to its needs. Issuing equity is expensive and dilutive; debt financing is less expensive and creates tax shields, but too much debt places a firm at greater risk. A firm that changes its capital structure, theoretically, must keep the interests of its shareholders foremost in mind, but it should minimize the financial risk to the enterprise. A set of measures of this type of risk is the capitalization ratio, the proportion of debt in the capital structure. The three variants of the capitalization ratio are debt-to-equity (total debt divided by shareholders' equity), long-term debt-to-capitalization (long-term debt divided by long-term debt plus shareholders' equity) and total debt-to-capitalization (total debt divided by shareholders' equity). What is reasonable in terms of the capitalization ratio depends on the industry and the future prospects of the firm. A company, for example, could have a relatively high ratio compared to its peers, but stronger near-term profitability capacity to pay down debt to reduce the ratio to a comfortable level.