What is Capitalization Ratio?
The Capitalization Ratio refers to the proportion of a company’s operations funded by debt and is used to assess its credit risk profile.
How to Calculate Capitalization Ratio (Step-by-Step)
The capitalization ratio gauges the total amount of debt in a company’s capital structure relative to its two capital sources, equity or debt.
Often referred to as the “debt-to-capital ratio”, the metric compares a company’s total debt to its total capitalization.
Companies generate revenue from their asset base, such as inventory and PP&E, which are purchased using financing from a source of capital. There are typically two main sources of capital:
- Total Equity: Paid-in-Capital, Retained Earnings, Equity Issuances
- Total Debt: Senior Debt, Corporate Bonds, Mezzanine Financing
Debt can consist of short-term and long-term borrowings like senior secured loans provided by bank lenders or issuances of corporate bonds.
In comparison, debt financing is considered to be “cheaper” than equity financing because of:
- Tax-Deductible Interest: The pre-tax income is reduced by interest expense on the income statement, as interest is tax-deductible – creating the so-called “interest tax shield”.
- Higher Priority: If the company were to file for bankruptcy and undergo liquidation, the claims held by debt holders are prioritized ahead of that of equity holders in terms of distributing recoveries.
The drawback to debt financing, however, is that there are fixed financing costs, which can lead to a potential default (i.e. missed interest payment, mandatory principal amortization, covenant breach).
Furthermore, the downside to equity issuances is that the additional shares issues can dilute ownership in the company.
Capitalization Ratio Formula
The capitalization ratio formula consists of dividing a company’s total debt by its total capitalization, i.e the sum of total debt and total equity.
When attempting to decide which line items qualify as debt, all interest-bearing securities with debt-like characteristics should be included.
However, “Total Debt” should typically consist of exclusively long-term debt.
How to Interpret Capitalization Ratio (High or Low)
The higher a company’s capitalization ratio, the more its capital structure is implied to be comprised of debt rather than equity.
Therefore, the company is at a greater risk of defaulting and becoming distressed, since the company is riskier due to its reliance on financial leverage.
By contrast, a lower capitalization ratio – which is viewed more favorably from a credit risk perspective – indicates that the company is less dependent on debt.
The relationship between the capitalization ratio and default risk is as follows:
- Higher Capitalization Ratio → More Default Risk
- Lower Capitalization Ratio → Less Default Risk
Debt to Capital Ratio Limitations
The debt-to-capital ratio is insufficient as a standalone metric to understand a company’s true financial health.
For instance, a company can utilize minimal debt because of a lack of access to debt financing, rather than by choice.
A company could also possess a lower debt-to-capital ratio than its peers, yet soon file for bankruptcy later.
One critical consideration when comparing the debt-to-capital ratio among different companies is that the companies with the option to raise significant amounts of debt capital are typically the most financially sound.
Why? Lenders tend to be risk-averse, especially senior lenders like corporate banks, so high-risk companies are typically more limited in being capable of raising debt capital.
