Capitalization refers to a company’s long-term financing – the investment made in the company by long-term creditors and owners.
Common Capitalization Ratios
Ratios can show the relationship of debt to equity, to total capitalization, and to total assets. The ratios may be calculated on book value or on the market value of the securities, if this information is available. Capitalization ratios suggest the extent to which a company is leveraged or “trading on the equity”. The higher the percentage of debt, the more a company is using borrowed money compared with equity supplied by stockholders.
Formulae to find common capitalization ratios
The common capitalization ratios include
- Leverage on Capital,
- Leverage on equity and
- Long-term debt to capital.
These ratios can be calculated as detailed below:
Leverage on Capital = Assets /(Long-Term Debt + Equity)
which shows how many dollars of assets have been (and, if optimal, can in the future be) acquired by each dollar of capital invested. The higher this ratio is, the more the company is relying on current liabilities to finance its operations.
The definition of long-term debt, unfortunately, is imprecise. Ratios calculated on the same balance sheet may therefore differ depending on how intermediate-term and short-term bank debt perpetually on the books are classified. Ratios included in loan covenants should be clearly specified if costly misunderstandings are to be avoided.
Leverage on Equity = Long-Term Debt / Equity
which suggests the ability of the owners to obtain long-term debt for each dollar they contribute as equity. Higher ratios usually belong to safer ventures, but startup situations may rely heavily on senior debt (which may have a contingent claim on the equity if all goes well). Troubled companies may inadvertently find themselves with a high leverage on equity because of operating losses that erode the equity balance.
An alternate method of calculating leverage is:
Long-Term Debt to Capital = Long-Term Debt / (Long-Term Debt+Equity)
One advantage of this ratio is that its limits are 0 percent and 100 percent, whereas the leverage-on-equity ratio is unbounded at the top.
A third useful ratio is the simple debt-equity ratio. These ratios may be derived from each other because both involve long-term debt and equity. For instance, if the long-term debt-to-equity ratio is 40 percent, then:
Debt / Equity = 40/100, and the long-term debt-to-capital ratio will be:
Debt / (Debt + Equity) = 40 / (40+100) = 29%
Alternatively, if the debt-to-capital ratio is 25 percent, then:
Debt / (Debt+Equity) = 25/100
If debt equals 25 of the 100, then equity must be 75. Therefore, debt to equity is 25:75 or 33.3 percent.