What are Capitalization Ratios?Capitalization ratios, also known as financial leverage ratios, are used to determine a company’s stability by comparing its long-term debt with its current equity and assets. A capitalization ratio provides investors and analysts with information about the extent to which a company is using its equity to finance its operational costs, and to what extent it is incurring new debt to do so. Capitalization ratios provide an indication of the company’s solvency and viability over the long term and allow more accurate risk assessments for prospective investors.
Typically, a company’s capitalization ratio is calculated by dividing the company’s long-term debt by the sum of the long-term debt and the shareholders’ equity, as follows:
• Long-term debt / (Long-term debt + shareholders’ equity) = Capitalization ratio
Shareholders’ equity is generally defined as the sum of preferred stock and common stock for the company in question. For example, a company that has $100,000 in long-term debt and $200,000 in common and preferred stocks would calculate its capitalization ratio in this way:
• $100,000 / ($100,000 + $200,000)
• $100,000 / $300,000, or 1/3, or 33%
This indicates a fairly healthy company; in fact, a 35% capitalization ratio is considered typical for most large companies during normal operations.
In contrast, a company that has $100,000 in long-term debt and $50,000 in common and preferred stock would instead produce this result:
• $100,000 / ($100,000 + $50,000)
• $100,000 / $150,000, or 2/3, or 67%
This is a seriously overleveraged company that presents financial risks to its investors and is unlikely to be able to obtain further credit in order to expand or finance new endeavors or meet unexpected expenses. Most economic analysts advise against incurring too much long-term debt in order to maintain the overall viability and market position of the company in question. In reality, a company would be unlikely to achieve a capitalization ratio of 67%, as creditors are usually unwilling to allow such a high percentage of debt to equity. Investors and analysts are likely to regard companies with overly high capitalization ratios as high-risk investments, and tend to shy away from purchasing shares in such companies.
Companies with exceptionally low capitalization ratios face a different problem. Underutilization of available equity can create a stagnant economic environment and prevent needed investments, damaging the potential for future earnings for their shareholders. By failing to responsibly leverage equity into investment, companies can miss valuable opportunities for growth and expansion. This translates into lower dividends for shareholders over the long run.
Companies that maintain low capitalization ratios are considered to be conservatively managed; this means that they offer lower risk than less conservative companies. Highly-leveraged companies offer the possibility of higher earnings by maximizing the value of initial shareholder investments. With those potential earnings, however, comes a higher degree of risk for investors; a downturn in business can result in a failure to meet the company’s outstanding financial obligations and the loss of value for shareholders. Thus, lower capitalization ratios offer significantly more security for current shareholders and a more attractive prospect for prospective investors.