FAM/U4 Topic 5 Market Capitalization Ratios
Capitalization ratio describes to investors the extent to which a company is using debt to fund its business and expansion plans. Generally, debt is considered riskier than equity (from company’s point of view). Hence the higher the ratio, the riskier the company is. Companies with higher capitalization ratio run higher risk of insolvency or bankruptcy in case they are not able to repay the debt as per the predetermined schedule. However, higher debt on the books could also be earnings accretive if the business is growing in a profitable manner (more on this in the analysis section).
The company uses this ratio to manage its capital structure and determine the debt capacity. Investors use it to gauge the riskiness of investment and form an important component of asset valuation (higher risk implies higher expected return). Lenders use it to determine if the company is within the predetermined limits and if there is more headroom to lend more money.
The capitalization ratio formula is calculated by dividing total debt into total debt plus shareholders’ equity. Here’s an example:
Total Debt to Capitalization = Total Debt / (Total Debt + Shareholders’ Equity)
You can also calculate the capitalization ratio equation by dividing the total debt by the shareholders’ equity.
Debt-Equity ratio = Total Debt / Shareholders’ Equity
Total debt refers to both long-term and short-term debts of a company
Shareholder’s equity refers to the book value of equity investment made by the investors
The debt-to-equity investment is calculated by simply dividing the two values. For total debt to cap ratio, we simply divide total debt with the sum or equity and debt (i.e. the total capital of a company)