The capitalization ratio compares total debt to total capitalization (capital structure). The capitalization ratio reflects the extent to which a company is operating on its equity.
Capitalization ratio is also known as the financial leverage ratio. It tells the investors about the extent to which the company is using its equity to support its operations and growth. This ratio helps in the assessment of risk. The companies with high capitalization ratio are considered to be risky because they are at a risk of insolvency if they fail to repay their debt on time. Companies with a high capitalization ratio may also find it difficult to get more loans in the future.
A high capitalization ratio is not always bad, however, higher financial leverage can increase the return on a shareholder’s investment because usually there are tax advantages associated with the borrowings.
The capitalization ratio is calculated by dividing the long-term debt by the total shareholder’s equity and long–term debt. This can be expressed as:
Capitalization Ratio = Long-Term Debt / (Long-Term Debt + Shareholder’s Equity)
The capitalization ratio is a very meaningful debt ratio because it gives an important insight into the use of financial leverage by a company. It 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 company’s capitalization (it should not be confused with the market capitalization) explains the make-up of the long-term capital of the company. Capitalization is also known as capital structure. A company’s long term capital consists of long - term borrowings and shareholder’s equity.
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 capitalization ratio indicates good quality of investment.