This is an advanced guide on how to calculate Capitalization Ratio with detailed interpretation, analysis, and example. You will learn how to utilize its formula to evaluate a business solvency.
Definition - What is Capitalization Ratio?
To assess a company’s ability to financially support their growth and operations, you can look to the capitalization ratio for insight.
Considered one of the more meaningful debt ratios, you can also gain perspective into how the company manages its leverage.
When a company can earn more on their borrowed funds than they pay in interest and fee expense on loans, that is called leverage.
Capitalization equates to the sum of shareholder equity plus long-term debt. We would want to use this ratio if we were considering whether to invest in a company.
We may also hear the ratio referred to as the “financial leverage” ratio and it determines the influence of each financial component to the company’s total capital.
Total capital is the sum of:
- Common stock
- Preferred stock
Shareholders equity is the difference between total assets and total liabilities.
Having higher leverage results in greater risk for an investor; however, it also means a greater chance for potentially larger returns. Think: “no risk, no return.”
Lower leverage calculations don’t always mean good things will be promised either. With less leverage, they may not have the funds needed to grow.
This is a ratio where the company needs to find their sweet spot where they have optimal availability to build, with a reasonable amount of debt.
Okay now you understand exactly what this ratio is about, let’s have a look at its formula.
We arrive at the capitalization ratio by dividing long-term debt by the sum of long-term debt and shareholders' equity.
Capitalization Ratio = Long-term Debt / (Long-term Debt + Shareholders’ Equity)
You can easily find the long-term debt and shareholders’ equity reported on a company’s balance sheet.
Now that you know the capitalization ratio formula, let’s consider a quick example so you can clearly understand how to calculate this ratio.
Assume that you are looking to measure the capital structure of Company A as well as how it uses leverage to expand its core operations.
For instance, this company has $1.57 million in long-term debt and $51 million in shareholders’ equity.
By using the above formula, we’ll arrive at the capitalization ratio as follows:
As you can see that Company A’s capitalization ratio is too low, which tells us that while their long-term debt is also low, investing in this organization is risky because the management might fail to use leverage to grow their business.
Now let’s look at another example. Assume that Company B has $95 million in total long-term liabilities and $60 million in shareholders’ capital.
By using the given formula, we’ll have the capitalization ratio of about 61.29%
This higher ratio means that the company is a higher risk investment because the management abused debt financing techniques to fund the company’s operations.
And obviously, as a value investor, you will not want to put your money in a high-debt business.
Interpretation & Analysis
There isn't a right or wrong answer to how much debt is the right amount, and the amount is going to vary based on the industry, the nature of the business, its products and where they are in their life cycle (start-up versus mature business).
But the easy and direct answer is, of course, if you have high equity and low debt, your company is probably a quality investment option because it is financially fit.
Generally speaking a capitalization ratio around 40% is considered standard for a larger organization working under normal operating conditions.
Having a high ratio indicates that the company is over-leveraged and has too much long-term debt, it will likely experience stunted growth because no one is going to extend further credit to them and it is a high-risk investment.
On top of that, competitors will attempt to profit from the condition because they will take advantage of this crippled state to improve their market share.
On the opposite end of the spectrum, having a ratio that is too low could also be a red flag because the company may be underutilizing their available equity.
That practice is more typical of a conservative management team, and while they are less risky, they are also putting themselves at risk for sluggishness, which could lead to reduced earnings and lower dividend potential for shareholders.
Cautions & Further Explanation
Having a solid ratio is great indication of the amount of risk associated with investing in the organization.
In terms of long-term debt, aside from the amount, be aware the company also need to maintain a strong record of compliance with the terms of all their loan agreements.
When a company takes on too much debt to use as their funding source, it’s an indication that there is higher risk for the investor.