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Debt Ratios: Capitalization Ratio

By Richard Loth (Contact | Biography)

The capitalization ratio measures the debt component of a company's capital structure, or capitalization (i.e., the sum oflong-term debt liabilities and shareholders' equity) to support a company's operations and growth.

Long-term debt is divided by the sum of long-term debt and shareholders' equity. This ratio is considered to be one of themore meaningful of the "debt" ratios - it delivers the key insight into a company's use of leverage.

There is no right amount of debt. Leverage varies according to industries, a company's line of business and its stage ofdevelopment. Nevertheless, common sense tells us that low debt and high equity levels in the capitalization ratio indicateinvestment quality.

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings had total long-term debt of $81.60(balance sheet), and total long-term debt and shareholders' equity (i.e., its capitalization) of $4,764.40 (balance sheet).By dividing, the equation provides the company with a negligible percentage of leverage as measured by the

capitalization ratio.

Variations:None

Commentary:A company's capitalization (not to be confused with its market capitalization) is the term used to describe the makeup ofa company's permanent or long-term capital, which consists of both long-term debt and shareholders' equity. A low levelof debt and a healthy proportion of equity in a company's capital structure is an indication of financial fitness.

Prudent use of leverage (debt) increases the financial resources available to a company for growth and expansion. Itassumes that management can earn more on borrowed funds than it pays in interest expense and fees on these funds.However successful this formula may seem, it does require a company to maintain a solid record of complying with itsvarious borrowing commitments.

A company considered too highly leveraged (too much debt) may find its freedom of action restricted by its creditorsand/or have its profitability hurt by high interest costs. Of course, the worst of all scenarios is having trouble meetingoperating and debt liabilities on time and surviving adverse economic conditions. Lastly, a company in a highlycompetitive business, if hobbled by high debt, will find its competitors taking advantage of its problems to grab moremarket share.

As mentioned previously, the capitalization ratio is one of the more meaningful debt ratios because it focuses on therelationship of debt liabilities as a component of a company's total capital base, which is the capital raised byshareholders and lenders.

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The examples of IBM and Merck will illustrate this important perspective for investors. As of FY 2005, IBM had acapitalization ratio of 32%, and Merck's was 22%. It is difficult to generalize on what a proper capitalization ratio shouldbe, but, on average, it appears that an indicator on either side of 35% is fairly typical for larger companies. Obviously,Merck's low leverage is a significant balance sheet strength considering its ongoing struggle with product liability claims.Eagle Materials and Lincoln Electric have capitalization ratios (FY 2006 and FY 2005) of 30% and 20%, which most likelyfall into the average and low ratio range, respectively. Zimmer Holdings' 2% capitalization ratio needs no furthercomment.

Next: Debt Ratios: Interest Coverage Ratio

Table of Contents

1) Debt Ratios: Introduction

2) Debt Ratios: Overview Of Debt

3) Debt Ratios: The Debt Ratio

4) Debt Ratios: Debt-Equity Ratio

5) Debt Ratios: Capitalization Ratio

6) Debt Ratios: Interest Coverage Ratio

7) Debt Ratios: Cash Flow To Debt Ratio

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Page 2 of 2bt Ratios: Capitalization Ratio

5/26/2011p://www.investopedia.com/university/ratios/debt/ratio4.asp