The Capitalization Ratio

The capitalization ratio, also referred to as the cap ratio, represents a financial ratio that measures a firm’s solvency. It does that by calculating the total amount of debt of a company. More specifically, it calculates the company’s financial leverage by comparing and contrasting the total debt with the total equity or a section of equity. There are primary types of capitalization ratios that are most common, namely the debt to equity ratio, the long-term debt ratio, and the debt to capitalization ratio.

Considering that both debt and equity account for two essential elements of the capital structure, they constitute the primary sources to finance operations.

Defining the Capitalization Ratio

In essence, the capitalization ratio informs investors to what extent a firm utilizes debt in order to finance its extension plans. Evidently, the higher the amount of debt, the higher the level of risk an investor takes. At the same time, from a company’s point of view, debt is considered as being riskier than equity.

To be more specific, companies with a high capitalization ratio feature an increased risk of insolvency or bankruptcy, in the case in which they are financially incapable of repaying the debt according to the predetermined schedule. However, higher debt on the books might also imply that the earnings of the business could be growing.

As for the reason why companies utilize this ratio, they do this in order to determine the debt capacity, in order to manage the capital structure in a more efficient manner. Meanwhile, investors utilize this ratio in order to assess the risk level of the investment.

Concurrently, it is a helpful tool for gauging asset valuation. The rule of thumb is that the higher the risk, the higher the expected return. On a different note, lenders also use this ratio to determine whether a company is within the predetermined limits and if there is additional headroom for lending money.

The Formula of the Capitalization Ratio

When it comes to the formula of this ratio, it is the following:

Essentially, as you can clearly notice, all the components of the formula can be easily found on the balance sheet of a company. In other words, the total debt represents both long-term and short-term debts, whereas the shareholder’s equity entails the book value of equity investment made by the investors.

Moving on, the debt-to-equity investment is merely calculated by dividing these two primary values.

As a rule of thumb, if the cap ratio is under 0.5, it is considered to be healthy. Nevertheless, this doesn’t mean that you should overlook the company and the industry context. For instance, for specific industries that hold physical assets, such as utility companies, it is quite common to have higher debt, in comparison to the equity. This is why it is of great importance for analysts to assess the broad scenario. This is the only way to get an overall view of the financial risk of a specific company.