# Capitalization Ratio

Updated: April 12, 2022

The capitalization ratio, also referred to as the cap ratio, is an indicator that measures the ratio between a company’s debts within its capital structure—the combination of debts and equities. Basically, the capitalization ratio gauges how dependent a company is to debt to be able to gain capital or money.

To raise capital, companies have two main ways: debt and equity (stocks and net income leftover). If a company relies too much on debt to finance its operation, it will be more prone to risks in the future. With that said, not all companies that are using a high amount of debt are necessarily in a bad shape. A company may deliberately rely on debt because of its advantages such as tax-deductible interest payments, easy access, flexibility, and debt’s convenience for not causing diluted ownership, unlike stock.

However, unsurprisingly, debts may cause a number of concerns. All debts have a due date so companies have to pay them back at some point, dissimilar to stock. Companies may also experience restrictions carried out by their creditor on their freedom of action. There is also the fear of not able to pay liabilities during financial adverse and the inability to compete with competitors because of too many debts.

## Capitalization Ratio Formula

$$Capitalization\: Ratio = \dfrac{Total\: Debt}{(Total\: Debt + Shareholders'\: Equity)}$$

To calculate this ratio, we need to know the total debt of a company—both short term and long term. The shareholders’ equity includes stocks such as common stock and preferred stock. The equation can be evaluated both in decimal or percentage.

There are three main ways to calculate capitalization ratio: debt-equity ratio, long-term debt to capitalization ratio, and total debt to capitalization ratio. Each of these measurements is acceptable to calculate the capitalization ratio of a company. For simplicity, we use total debt to capitalization ratio that includes all debts.

This version of the capitalization ratio gives a general assessment of how a company performs by how it also includes short term debt. Another ratio (long-term debt to capitalization) only put long term debt to the equation to give more emphasis on financial leverage.

With the total debt to capitalization formula, we measure the ratio of the total debt of a company against its total capitalization—the combination of debts and shareholders’ equity. In terms of corporations, we can simply treat “shareholder’s equity” as simply “equity”. Both phrases point out to the net amount of total assets minus total liabilities.

Generally, a lower ratio is better since it means that the company is using less debt and more equity. Although, when comparing capitalization ratios of multiple companies, it’s important to only use companies within the same industry. Different types of companies handle debts and equities differently. The acceptable ratios for a company vary depending on the industry it operates.

On the contrary, a company with a very low capitalization ratio cannot always be considered better than those with a high capitalization ratio either. While the said company may have a lower risk of conducting its business, we can also assume that the company fails to leverage funds for its operation. In the long run, the company may struggle to grow its business since it lacks the capital to do so.