Capitalization Ratio

Definition

The capitalization ratio compares total debt to total capitalization (capital structure). The capitalization ratio reflects the extent to which a company operates on its equity.

The capitalization ratio is also known as the financial leverage ratio. It tells investors the extent to which the company is using its equity to support its operations and growth. This ratio helps in assessing the risk. Companies with a high capitalization ratio are considered risky because they are at risk of insolvency if they fail to repay their debts on time. Companies with a high capitalization ratio may also find it difficult to obtain more credit in the future.

A high capitalization ratio is not always bad, but higher financial leverage can increase the return on a shareholder's investment because there are usually tax advantages associated with borrowing.

Calculation (formula)

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. Total capital is the capital raised from shareholders and 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 determining the appropriate or optimal amount of debt. Leverage depends on the type of industry, the line of business, and the stage of development of the company (and its products). However, it is generally accepted that a low level of debt and a high level of equity in the capitalization ratio indicate good investment quality.

For investors, capitalization ratio can be used as a tool to assess the risk and return of a potential investment. Companies with lower capitalization ratios are often considered to be less risky than those with higher ratios, as they have less debt and more equity to absorb potential losses. However, investors should also consider that a low capitalization ratio can also be a sign of a company that is not leveraging its capital to generate growth. For financial analysts, capitalization ratio can be useful for comparing companies within the same industry, as it provides a way to measure a company's debt levels relative to its market value. It also can be used to compare a company over time to see if there is an increase or decrease in debt levels and how it affects the company's financial health.

In summary, Capitalization ratio is an important metric to be controlled by any entity, as it provides valuable information about a company's financial leverage and risk profile, which can help to inform investment decisions and assess the company's overall financial health.

How to improve Capitalization Ratio

There are several ways to improve a company's capitalization ratio:

1. Reduce debt: One of the most straightforward ways to improve a company's capitalization ratio is to pay off or reduce outstanding debt. 

2. Increase equity: Another way to improve a company's capitalization ratio is to increase the company's equity. This can be done by issuing new shares of stock or by retaining earnings instead of distributing them as dividends.

3. Generate cash flow: Improving a company's cash flow can also help to improve its capitalization ratio. A company that generates positive cash flow can use that cash to pay down debt, which will improve its debt-to-equity ratio.

4. Sell non-core assets: A company can also improve its capitalization ratio by selling non-core assets, such as real estate or investments, and using the proceeds to pay down debt.

5. Increase profitability: Improving profitability can also help a company to improve its capitalization ratio. A company that is generating higher profits will have more cash flow to pay down debt and may be able to retain more earnings to increase its equity.

It's important to note that improving capitalization ratio alone does not guarantee the success of a company, it should be considered along with other financial ratios, such as profitability and cash flow, and analyzed in the context of the company's industry and overall financial health.