What Does Capitalization Ratio Mean?
Capitalization ratio, also known as financial leverage ratio, is the ratio that determines the contribution of each financial component to the total capitalization of the company. There are many components to a company's capital such as debt, common stock and preferred stock. The capitalization ratio determines the percentage of contribution from each of these components. This ratio is mostly used in the context of an organization's earnings and cash flow situation.
Capitalization ratio is calculated using the following formula:
Capitalization Ratio = Long Term Debt / (Long Term Debt + Shareholders Equity)
Divestopedia Explains Capitalization Ratio
The capitalization ratio is to let investors know what percent of the company's equity is used to support its growth and operations. At the same time, it also gives an idea of the company's debt and its percentage in the overall capital. With this information, it is possible to assess the risk, especially with respect to default.
In general, companies tend to have a high capitalization ratio if the contribution of debt to the capital structure is much higher than the equity. Such a high capitalization ratio increases the risk of the company as it will be forced to declare insolvency if the debts prove to be too much to pay. Also, companies that have a high capitalization ratio may find it difficult to get a loan or may only get high interest loans because creditors will assess the risk level as being too high. However, the upside to a high capitalization ratio is that the company will be able to make the most of tax advantages associated with borrowing. As a result, the return on investment for shareholders will be high.