The capitalization ratio is a measurement of the portion of debt in the company’s capital structure. It measures the total debt fo a company as part of the total capitalization. Another way to look at is how much a company is using its equity to support its operations and growth. In essence, the capitalization ratio shows how a company raises money or capital (by using debt or equity) as a method to finance its operations.
The formula for calculating capitalization ratio uses the total debt of the company divided by total debt + shareholders equity.
Capitalization Ratio = Total Debt / (Total Debt + Shareholder’s Equity)
The total debt and shareholders equity numbers can be found on the company balance sheet.
There is a variation of the capitalization ration called long term debt to capitalization ratio that indeed of total debt uses only the long term debt. The formula for calculating this version of the capitalization ration is:
Long Term Debt to Capitalization Ratio = Long Term Debt / (Long Term Debt + Preferred stock + Common stock)
This version of the formula takes that Available Capital = Long Term Debt + Common Stock + Preferred Stock
There is no standard for setting the right or optimum capitalization ratio, however, it is generally accepted that low capitalization ratio (and low debt) and high equity levels are a sign of a good quality of business. Since capitalization ratio is a finance leverage ratio a higher number will indicated that a company is more risky because they have higher debt and therefore have higher risk of not being able to repay their debts on time (become insolvent) in a situation of a crises. Companies with a high capitalization ratio may also find it difficult to get more loans in the future. As always what is considered normal capitalization ratio will depend on the industry, the of the business and the stage the business is currently(fast growing businesses might use more leverage to finance their growth).
The capitalization ratio tells the investors about the extent to which the company is using its equity (or debt) to support its operations and growth and this helps the investors in the assessment of risk and company’s financial health. It’s a way to asses whether the company is raising additional capital by issuing more stock can dilute ownership in the company or by using debt. Rising capital vs debt has some advantages like: Interest payments are tax-deductible, debt also doesn’t dilute the ownership (unlike stock issuance). Rising capital vs equity (by issuing more stock) can dilute ownership in the company but on the other hand, equity doesn’t have to be paid back.