The capitalization ratio compares total debt to total capital structure (capitalization). The capitalization ratio reflects the extent to which a company is supporting its operations and growth using its equity.
The Capitalization Ratio compares total debt to total capital structure (capitalization). The ratio reflects the extent to which a company is supporting its operations and growth using its equity. Capitalization Ratio is also known as the Financial Leverage Ratio
Capitalization Ratio Formula
The Capitalization Ratio is calculated by dividing the long-term debt by the total shareholder’s equity and long–term debt. Shareholders’ equity is generally defined as the sum of preferred stock and common stock for the company in question.
Capitalization Ratio Example
A company that has $500,000 in long-term debt and $1,000,000 in common and preferred stocks would calculate its capitalization ratio in this way:
• $500,000 / ($500,000 + $1,000,000)
• $500,000 / $1,500,000, or 1/3, or 33%
This indicates a fairly healthy company; in fact, a 35% capitalization ratio is considered typical for most large companies during normal operations.
Capitalization Ratio Interpretation
The Capitalization Ratio is a very meaningful debt ratio as it gives an important insight into the company's use of financial leverage. The ratio focuses on the relationship of long-term debt as a component of the company's total capital base. The total capital is the capital raised by the shareholders and the lenders.
The Capitalization Ratio helps assess the risk of an investment. Companies with high a Financial Leverage Ratio are at risk of insolvency if they fail to repay their debt on time. Companies with a high ratio may also find it difficult to get more loans in the future.
However, a high Capitalization Ratio is not always bad. Higher financial leverage can increase the return on a shareholder’s investment because usually there are tax advantages associated with the borrowings. There is no standard or benchmark for setting the right or optimum amount of debt.
Leverage will depend on the type of industry, line of business and the stage of development of the company (and its products). However, it is commonly understood that low debt and high equity levels in the Financial Leverage Ratio indicates good quality of investment.