What Are Capitalization Ratios?
Capitalization ratios are indicators that measure the proportion of debt in a company’s capital structure. They are among the more meaningful debt ratios used to assess a company's financial health.
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:
- 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)
Capitalization ratios are also known as leverage ratios.
Understanding Capitalization Ratios
Basically, capitalization ratios deal with how a company raises money or capital. Debt and equity are the two main methods a company can use to finance its operations.
Debt has some advantages. Interest payments are tax-deductible. Debt also doesn’t dilute the ownership of the firm like issuing additional stock does. When interest rates are low, access to the debt markets is easy, and there is money available to lend. Debt can be long-term or short-term and can consist of bank loans of the issuance of bonds. Equity can be more expensive than debt. Raising additional capital by issuing more stock can dilute ownership in the company.
On the other hand, equity doesn’t have to be paid back. A company with too much debt may find its freedom of action restricted by its creditors and/or have its profitability hurt by high interest-rate payments. The worst of all scenarios is having trouble meeting operating and debt liabilities on time during 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.
Comparing capitalization ratios of companies is more effective when they're compared to the ratios of companies within the same industry.
- Capitalization ratios measure the proportion of debt in a company’s capital base, its funds from lenders and stockholders.
- Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio, and total debt to capitalization ratio.
- The acceptable capitalization ratios for a company are not absolute but dependent on the industry in which it operates.
Types of Capitalization Ratios
Let's examine the three capitalization ratios more closely.
Calculated by dividing the company’s total liabilities by its shareholders' equity, the debt-equity ratio compares a company's total obligations to the total ownership stake of its stockholders. This is a measurement of the percentage of the company’s balance sheet that is financed by suppliers, lenders, creditors, and obligors versus what the shareholders have committed. As a formula:
The debt to equity ratio provides a vantage point on a company's leverage position, in that it compares total liabilities to shareholders' equity. A lower percentage means that a company is using less leverage and has a stronger equity position. However, it should be kept in mind that this ratio is not a pure measurement of a company's debt because it includes operational liabilities as part of total liabilities.
Long-term Debt to Capitalization Ratio
The long-term debt to capitalization ratio, a variation of the traditional debt-to-equity ratio, shows the financial leverage of a firm. It is calculated by dividing long-term debt by total available capital (long-term debt, preferred stock, and common stock). As a formula:
Contrary to intuitive understanding, using long-term debt can help lower a company's total cost of capital, since lenders don't share in profits or stock appreciation. Long-term debt can be beneficial if a company anticipates strong growth and ample profits permitting on-time debt repayments. On the other hand, long-term debt can impose great financial strain on struggling companies and possibly lead to insolvency.
Total Debt to Capitalization Ratio
The total debt to capitalization ratio measures the total amount of outstanding company debt (both long-term and short-term) as a percentage of the firm’s total capitalization.
The formula for total debt to capitalization looks like this:
Example of Capitalization Ratios
Different ratios can yield different results, even for the same company.
Let's 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%
Significance of Capitalization Ratios
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.
However, 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 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 two, 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.