Banking Financial Analysis Investment Markets

Capitalization Ratio

What is Capitalization Ratio ?

The capitalization ratio is divided by long term debt to total capitalization i.e. capital structure. That’s why it also known as capitalization structure ratio.

The capitalization ratio reflects the extent to which an organization is working on its equity.

The capitalization ratio, often called the Cap ratio, is a financial ratio that measures a company’s solvency by calculating the total debt component of the company’s capital structure of the balance sheet.

That means, by using this ratio company manage its capital structure and determine the debt capacity.

Capitalization ratio is also called the financial leverage ratio. It tells the investors about the extent to which the organization is using its equity to support its operations and growth.

This ratio helps in the assessment of risk. The companies with high capitalization ratio are considered to be risky (higher the risk implies higher the gain) but sometimes it fails to repay the debts.

Companies with a high capitalization ratio may also locate it difficult to get more loans in the future.

 

Capitalization Ratios Formula

1.        Debt to Equity Ratio

 

Let’s Look at Formula of Debt to Equity Ratio

Debt-Equity Ratio = Total Debt / Shareholders’ Equity

Long formula:

debt Equity Ratio

Debt Equity Ratio

Shareholders’ Equity

Here we will take the total debt into account and will compare with the shareholders’ equity. This is the basic capital structure ratio which gives us an idea about how much debt and equity are injected into the capital of the company.

Here total debt includes both short term and long term debt and shareholders’ equity includes everything from share capital, reserve, non-controlling interest and equity attributable to the shareholders.

In case of a debt-free firm, the debt-equity ratio would be nil and then the idea of capitalization ratio is irrelevant.

 

2.      Long Term Debt to Capitalization

 

Let’s look at formula of Long Term Debt to Capitalization

Capitalization Ratio = Long term Debt / Capitalization

Capitalization means the sum of long term debt and the shareholders’ equity.

This is the first most important ratio of capitalization. We are looking at all three to understand the proportion of debt from all angles. This ratio tells us about the proportion of long term debt compared to capitalization.

3.    Total Debt to Capitalization

Let’s learn the formula of Total Debt to Capitalization.

Capitalization Ratio = Total Debt / Capitalization

The only difference between the previous capitalization ratio and this one is the inclusion of short term debt. In this ratio, we determine at total debt and find out the proportion of total debt compared to capitalization.

Total debt means both long term debt and short term debt. And capitalization means as usual the debt plus equity. But in this case, the capitalization would also include short term debt (that means capitalization = long term debt + short term debt + shareholders’ equity).

Advantage of Capitalization Ratio

  1. The analysts are able to make key strategic  for decisions and also to keep and reinvest more company earnings.
  2. This ratio company manage its capital structure and determine the debt capacity.
  3. It provides the message about the solvency of a company.
  4. This ratio helps in the assessment of risk.
  5. The risk associated with company’s growth and future of the company.
  6. It gives an idea to the long-term lender regarding extent of security of the debt.
  7. Low debt equity ratio reflects more security

Disadvantage of Capitalization Ratio

  1. Assumes the company on future earnings is that the projected future earnings may wrong.
  2. Unforeseen circumstances could cause earnings to be much less than anticipated.
  3. In this ratio of future incomes does not take as liabilities into account.

Analysis and Interpretation Capitalization Ratio

Generally, a cap ratio of less than 0.5 is considered healthy, but we need to look at the ratio in the context of the company’s past and industry averages.

For industries, which own physical assets, (like utility companies) it is common to have much higher debt compared to the equity. Sometimes a particular bond or loan is linked to a particular project or asset.

Debt-to-equity ratio with low value like  0.1, would suggest that the company is not fully using the cheaper source of financed debt.

while a debt-to-equity ratio that is high like 0.9 would indicate that the company is facing a very high financial risk.

As with any ratio, analysts need to spend considerable effort to decode this ratio and understand the underlying drivers.

Every industry will have a typical capital structure (with company specific differences) and this will determine the cap ratio maintained by the company.

Corporate actions (such as M&A) can also impact the capital structure of a company. Especially, if a company is buying distressed assets then the combined capital structure might be debt heavy.

Analyst need to be aware about all these contexts before forming an opinion on the financial health of a company.

Analyst should also be aware of the optimal capital structure the company management is targeting. Cap ratio is used in asset pricing (or company valuation) as an input to the discount rates.

Hence, analysts should focus on the target capital structure to understand the future risk potential.

Analysts should always ascertain if this target structure is practically feasible given the industry dynamics, company operations, and macro-economic condition. Management might guide towards very aggressive targets just to appease the investor community, but it is the job of an analyst to understand the sensibility of this plan.

Details about the management view can be found in the Management discussion section of a 10-K or the transcripts of the quarterly earnings calls.

Having debt on the balance sheet is not always negative. Debt should be less than equity and gives some extend of tax shield in terms of interest repayment. Hence, use this carefully, debt mat have a greater impact on the income.

However, too much debt restricts the management decision making as lenders normally put in place covenants which prohibit management from taking certain actions which can jeopardize the interest of the lender.

Why do Debt-to-Equity Ratios matter?

In general, a high debt-to-equity ratio indicates that an organization might not be ready to generate enough cash to satisfy its debt obligations. However, low debt-to-equity ratios can also indicate that an organization isn’t taking advantage of the increased profits that financial leverage may bring.

Capital-intensive industries incline to possess higher debt-to-equity ratios than low-capital industries since capital-intensive industries ought to purchase more material goods, plants and equipment to work-done.

This is why comparison of debt-to-equity ratios is usually most meaningful among companies within a similar industry, and also the definition of a “high” or “low” ratio should be made within this context.

Lenders and investors often prefer low debt-to-equity ratios because their interests are better protected in the event of a business downward mode. Thus, firms with high debt-to-equity ratios might not be ready to attract additional capital.

Financial Statement Position as on 31st March 2020

You may also see

Current Ratio

Quick Ratio 

Net Working Ratio etc

Example of Capitalization Ratio

Ratio Systems Limited
Financial Statement of as at 31st March 2020
2020
USD
ASSETS
Non-current assets
Property, plant & equipment130,000
Goodwill30,000
Intangible assets60,000
220,000
Current assets
Inventories12,000
Trade receivables25,000
Cash and cash equivalents8,000
45,000
TOTAL ASSETS265,000
EQUITY AND LIABILITIES
Equity
Share capital100,000
Retained earnings50,000
Revaluation reserve15,000
Total equity165,000
Non-current liabilities
Long term Loan15,000
Deferred tax8,000
Finance Lease Obligation12,000
Current liabilities
Trade and other payables35,000
Short-term borrowings10,000
Current portion of long-term borrowings15,000
Current tax payable5,000
Total current liabilities65,000
Total liabilities100,000
TATAL EQUITY AND LIABILITIES265,000

 

Calculate debt-to-equity ratio of Ratio Systems Limited.

Debt-Equity Ratio1=Debt
Equity
=52,000 (W1)=  0.32
165,000

 

Debt-Equity Ratio2=Long-Term Debt
Equity
=42,000 (W2)=  0.25
165,000

 

Debt-Equity Ratio3=Long-Term Debt
Equity + Long-Term Debt

 

=42,000 (W2)=  0.20
165,000 + 42,000

 

Working 1: Debt

Non-Current portion of long-term loan15,000
Current portion of long-term loan15,000
Deferred Tax
Finance Lease Obligation12,000
Trade and other payables
Short-term borrowings10,000
Current tax payable
52,000

Tax obligations, and trade & other payables have been excluded from the calculation of debt as they constitute non-interest bearing liabilities.

Working 2: Long-Term Debt

Non-Current portion of long-term loan15,000
Current portion of long-term loan15,000
Deferred Tax
Finance Lease Obligation12,000
42,000

All current liabilities have been excluded from the calculation of debt other the $15000 which relates to the long-term loan classified under non-current liabilities.

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