What to Do
Companies use either equity or debt to finance their operations. Although risk is a function of every business, the balance between equity and debt may intensify or diminish that risk. Equity offers ownership to shareholders in exchange for funds. If the directors see fit, dividends may be issued, but they are not under obligation. On the other hand, debt has to be paid off at some point, together with the interest accrued.
There are various calculations to describe this balance, depending on the focus of the analysis. These include debt-to-capital ratio, debt-to-equity ratio, and interest coverage. Here, we’ll look at the most straightforward version, which is known simply as the “capitalization ratio.” There are two approaches to the formula:
or
Example:
Suppose a business has $10,000 of long-term debt. The owners have equity worth $7,000, so:
The ratio is also known as a “component percentage” because it compares debt with total capital (debt plus equity) or equity capital—revealing how far a business relies on loans to support its operation.
What You Need to Know
- Capitalization ratios are more meaningful if compared with other facts and figures. For example, if an investor understands how the data compares with that of other key players in the market, or with industry averages, it becomes much more useful. Similarly, when data from a longer period is analyzed, trends emerge that will say much more about a company’s policies and strategy than a single set of figures.
- Capitalization ratios should also be analyzed in relation to data like earnings and cash flow, alongside comparable information from competitors. Bear in mind that figures that seem good for one sector may be less impressive in another, and vice-versa.
- Some capitalization ratios use formulas based on the book value of equity (the stock). These ratios are used less often, but it’s worth noting that they can be misleading, particularly in relation to other ratios, because a company’s book value may be very different from its market value. The latter tends to be much higher, as it is a reflection of how investors rate a company rather than the value of its net assets.
Where to Learn More
Web Sites:
FX Words: www.fxwords.com
Net MBA (for an overview of key financial ratios): www.netmba.com/finance/financial/ratios
