Capitalization Ratios

What Are Capitalization Ratios?

Capitalization ratios are indicators that measure the extent of debt in a company's capital structure. They are among the more significant debt ratios used to evaluate a company's financial wellbeing.

Capitalization ratios incorporate the debt-equity ratio, long-term debt to capitalization ratio, and total debt to capitalization ratio. The formula for every one 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 otherwise called leverage ratios.

Grasping Capitalization Ratios

Fundamentally, capitalization ratios deal with how a company fund-raises or capital. Debt and equity are the two primary methods a company can use to finance its operations.

Debt enjoys a few benefits. Interest payments are tax-deductible. Debt additionally doesn't weaken the ownership of the firm like giving extra stock does. At the point when interest rates are low, access to the debt markets is simple, and there is money accessible to loan. Debt can be long-term or short-term and can comprise of bank loans of the issuance of bonds. Equity can be more costly than debt. Raising extra capital by giving more stock can weaken ownership in the company.

Then again, equity doesn't need to be paid back. A company with too much debt might find its freedom of action restricted by its creditors as well as have its profitability wounded by high interest-rate payments. The most horrendously terrible of all situations is experiencing difficulty meeting operating and debt liabilities on time during adverse economic conditions. In conclusion, a company in a highly competitive business, in the event that limped by high debt, will find its competitors exploiting its concerns to get more market share.

Looking at capitalization ratios of companies is more effective when they're compared to the ratios of companies inside a similar industry.

Types of Capitalization Ratios

We should look at the three capitalization ratios all the more closely.

Debt-Equity Ratio

Calculated by isolating 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 providers, lenders, creditors, and obligors versus what the shareholders have committed. As a formula:

The debt to equity ratio gives 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 utilizing less leverage and has a stronger equity position. Nonetheless, it ought to be remembered that this ratio is certainly not a pure measurement of a company's debt since it incorporates 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 partitioning long-term debt by total accessible capital (long-term debt, preferred stock, and common stock). As a formula:

In spite of natural getting it, utilizing long-term debt can assist with lowering a company's total cost of capital, since lenders don't share in profits or stock appreciation. Long-term debt can be beneficial on the off chance that a company expects strong growth and adequate profits allowing on-time debt repayments. Then again, long-term debt can impose great financial stress on striving companies and perhaps 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 seems to be this:

Illustration of Capitalization Ratios

Various ratios can yield various outcomes, even for a similar company.

We should 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 processed 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 in view of the tax shield of debt, a higher extent of debt increases the risk of bankruptcy for a company.

Notwithstanding, the acceptable level of capitalization ratios for a company relies upon the industry in which it operates. Companies in sectors like utilities, pipelines, and broadcast communications — which are capital intensive and have unsurprising cash flows — will commonly have capitalization ratios on the higher side. On the other hand, companies with relatively couple of assets that can be pledged as collateral, in sectors like technology and retail, will have lower levels of debt and accordingly 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 well known leverage ratio, measures the ratio of a company's earnings before interest and taxes (EBIT) to its interest expense. A ratio of two, for example, shows the company generates $2 for each dollar in interest expense.

Likewise with all ratios, a company's capitalization ratios ought to be followed after some time to distinguish in the event that they are stable. They ought to likewise be compared with comparative ratios of peer companies, to find out the company's leverage position relative to its peers.

Highlights

Capitalization ratios measure the extent of debt in a company's capital base, its funds from lenders and stockholders.
Capitalization ratios incorporate 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 yet dependent on the industry in which it operates.