Capitalization Ratio is used to measure the debt component of a company in its capital structure. It includes the sum of long term debt liabilities and the shareholder’s equity. The ratio is basically calculated to support the company’s growth and operations.
We usually divide the long term debt of a company by the sum of long term debt and the shareholders equity. Many analysts rate this as one of the meaningful ratios among the debt ratios. They believe that it provides and insight to the company’s leverage and its actual impact.
The leverage varies from industry to industry and from one line of business to another. This is the reason why there is no right level of debt that is ideal for a company. However with a simple sense of investment and its acceptability we can determine that low debt and high levels of equity in the capitalization ratio indicates the investment quality in a company.
In order to calculate capitalization ratio we use the following formula:
Capitalization Ratio= Long Term Debt/ (long term Debt + Shareholders Equity)
In order to explain the above ratio and its impact on a company we take the figures from the Balance Sheet of Reliance Industries. As per the Balance sheet for the year ended 31st March 2011, the long term debt liabilities stood at Rs.67,396.68/- crores and the shareholders Equity stood at Rs.151,540.32/- crores. Thus Capitalization Ratio stood at:
67,396.68/(67,396.68+151,540.32)= 30.06%. When analyzed we the percentage signifies that the company has used a pretty decent leverage of its debts at 30.06%.
Uses of Capitalization ratio:
The capitalization of a company is the term that is used to makeup of a company’s long term capital or the permanent capital of the company. It consists of both the long term debt as well as the shareholder’s equity. Generally a low level of debt is appreciated and marks for the healthy proportion of equity in the company’s capital structure and is a strong indicator of the financial fitness of the company. An intelligent and appropriate use of the leverage of a company, the resource available to a company grows and helps it to expand across its operational base. Therefore it is assumed as well as essential that the company earns more than the interests payable on the borrowed funds by the company.
Use the debts to leverage too highly by the company may loose out its freedom to the creditors or lenders of the company. In the time of downturn it may prove costly for the company as it may be in trouble of meeting its operating and debt liabilities from time to time. Thus as we mentioned before capitalization ratio is one such meaningful debt ratio as it majorly focuses on the relationship of the debt liabilities as a prime component of the company’s total capital base (i.e. capital raised by the shareholders and the lenders).
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Mohan Bhupathiraju
Mohan Bhupathiraju is a co-founder & editor at LastBull.com. Handled multiple projects in BFSI for few of the Forbes top 100 companies. He works in IT industry in the US. Presently working on start up Ideas in Finance & Technology niches.
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As capitalization ratio shows the growth of the company and its actual position. Its really helpful in measuring the company performance and take the required action to sort out the remedies. Useful information, keep it up.