Capitalization ratio is also known as the cap ratio which is used for the calculation of the solvency of the company.
Capitalization ratio calculates the financial leverage of the firm or company by comparing the total debt with equity or section of the equity.
There are different types of capitalization ratio in which to most common ratios are
- Debt to Equity Ratio
- The long term debt ratio
- Debt to capitalization ratio
The capital structure of the company has 2 main component to finance its operation that is debt and equity.
Definition: What is the Capitalization Ratio?
Through the capitalization ratio, investors know the debt which company funds to its business and expansion plans.
With high capitalization ratio company have high risks of insolvency and bankrupt If the company can’t repay the debt according to schedule.
If the business is profitable then high debt is the cause of more earning.
For the determination of debt capacity of for managing the capital structure, this ratio is used. Investors use the capitalization ratio to measure the riskiness of the company.
Capitalization Ratio Formula
Capitalization ratio formula can be calculated by divide the total debt by the sum of total debt and shareholder’s equity that is.
Capitalization ratio= total debt/(total debt + shareholder’s equity)
From the balance sheet, all the values found which is required to find the capitalization ratio. Total debt means the sum of long term and short term debt.
Shareholder’s equity means the investment of the investor on the equity. To find the debt to investment ratio we just divide both values.
Whereas to find the debt to capitalization ratio we divide the total debt with the sum of equity and debt.
Now we take an example to calculate the capitalization ratio.
Capitalization Ratio Example
Here we take the example of a company which activities f previous 3 years are mentioned in the following table.
In the first year debt to equity ratio was 0.9 for 1USD of equity which implies and USD 0.9 of debt there was in books. At the end of the third year, it reduces to 0.6
On the other hand for the first year debt to capital ratio of the company is 0.47 which indicate that 47 % capital structure funded by debt and 53 % is by equity. To implying higher usage of equity this ratio reduced to 0.38.
Analysis and Interpretation
If the capital ratio of the company is less then 0.5 then company consider being a healthy company. But mostly we look at the ratio in the context of part of the company.
Utility company or companies like this have higher debt as compare to the equity. Ther may be linked bond or loan with the particular assets of the company.
From the above example, we observe that if the cap ratio is reducing then the processing of the balance sheet delivering. In this case, the as compare to the debt, equity is a cheaper source of funding.
For every company, there is the typical capital structure which used to determine the capital ratio of the company maintained by the company.
If the company buying assets then it will have heavy debt for the combine capital structure. To analyze the financial health of the company analyst calculate all the points like this.
Check More Financial Ratios: