Capitalization Ratios - Explained
What are Capitalization Ratios?
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What are Capitalization Ratios?
Capitalization ratio is a financial metric that measures the solvency of a firm by examining its capital structure which is the combination of equity and debt. Often called cap ratio, this ratio measures the degree of debt in a company's capital structure, it also shows the extent at which equity is used to finance a company's operations.
What are the common Capitalization Ratios?
There are the common capitalization ratios, they are;
- Debt to equity ratio
- Long-term debt ratio to capitalization ratio
- Debt to capitalization ratio
The capitalization ratio is otherwise called the financial leverage ratio. A high proportion of debt in a company signifies a possible insolvency or bankruptcy in the company while a high capitalization ratio means there is enough equity with which a company operates. A Little More on What is a Capitalization Ratio Capitalization ratios are important metrics used in calculating the total level of debt in a company's capital structure, as well as the proportion of equity. Debt and equity are the major parts of capital structure for companies, this means a company can run its operations either with debt financing or equity financing. Capitalization ratios determine the financial leverage of a company by comparing the total debt with total equity. There are three major capitalization ratios and they are calculated as follows;
- Debt-Equity ratio = Total Debt / Shareholders' Equity
- Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders Equity)
- Total Debt to Capitalization = Total Debt / (Total Debt + Shareholders' Equity)
Through a capitalization ratio, an investor can know what type of capital structure exists in a company and whether a company funds its operations through debts or equity. Excess debt is not good for the company, it can lead to bankruptcy and eventual collapse of such form. Given the high risks attributed to debts, equity financing is more favorable for a business. The acceptance level of capitalization ratios differ from one industry to another based on numerous factors including the tangible assets held by a company. Regardless of what this acceptance level, keeping a good track of capitalization ratios is what companies must place a premium on.