Capitalization Ratio

What is the Capitalization Ratio?

Capitalization ratios are a set of ratios that help an analyst in determining how the capital structure of the company will affect if an investment is made in the company – this set includes debt to equity, long term debt to market cap and total debt to market cap as helpful ratios.

Pepsi Debt to Equity was at around 0.50x in 2009-1010. However, it started rising rapidly and is at 2.792x currently. What does this mean for Pepsi? How did its Debt to Equity RatioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. read more increase dramatically? Is this good or bad for Pepsi?

With this ratio, we try to understand how much a company has injected “debt” into its capital structure. It’s simple; we will check out the proportion of debt in the total capital. To understand this, we need to first understand the capital structure.

The capital structure depicts the proportion of the equity and debt of the capital of a company. The rule of thumb is for any company is to maintain a 2:1 ratio between its equity and debt. But in real life, it always doesn’t happen. So, we as investors need to look at it and ascertain how much equity and debt are there in a company’s capital.

But only one ratio would not be able to give us an accurate picture. So we will look at three ratios through which we will understand the debt in the capital. This is also called the financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more ratio. The three ratios that we will look at are – Debt-Equity Ratio, Long-term Debt to Capitalization Ratio, and Total Debt to Capitalization Ratio.

Let’s have a look at the formulas of these three ratios.

Capitalization Ratio Formula

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Source: Capitalization Ratio (wallstreetmojo.com)

#1 – Debt to Equity Ratio

First, let’s look at the Debt-Equity ratio.

Debt-Equity Ratio = Total Debt / Shareholders’ Equity

Here we will take the total debt into account and will compare it with the shareholders’ equity. This is the basic capital structure ratio, which gives us an idea about how much debt and equity are injected into the capital of the company. Here total debt includes both short term and long term debt, and shareholders’ equity includes everything from share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more, reserve, non-controlling interest, and equity attributable to the shareholders.

In the case of a debt-free firm, the debt-equity ratio would be nil, and then the idea of this ratio is irrelevant.

#2 – Long Term Debt to Capitalization

Let’s have a glance at the next ratio.

Capitalization Ratio = Long term Debt / Capitalization

This is the first most important ratio of capitalization. We are looking at all three to understand the proportion of debt from all angles. This ratio tells us about the proportion of long term debt compared to capitalization.

Capitalization means the sum of long term debtTerm DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more and the shareholders’ equity. In the example section, we will understand how to calculate it.

#3 – Total Debt to Capitalization

Let’s look at the third most important ratio.

Capitalization Ratio = Total Debt / Capitalization

The only difference between the previous ratio, and this one is the inclusion of short term debt. In this ratio, we will look at total debt and find out the proportion of total debt compared to capitalization.

Total debt means both long term debt and short term debt. And capitalization means, as usual, the debt plus equity. But in this case, the capitalization would also include short term debt (that means capitalization = long term debt + short term debt + shareholders’ equity).

In the example section, we will see how to calculate this ratio.

Interpretation

If we take into account the above three ratios, we would be able to understand how a company is doing in the long run.

But we need to use discrimination while judging the leverage of a company depending on the industry it operates in. A company that is very capital intensive and has predictable cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more usually has a higher debt ratio. For example, companies in telecommunications, utilities, and pipelines are very capital intensive and have reasonably higher cash flows. Thus, the capitalization ratios for these sorts of companies are higher in normal scenarios.

In other cases, IT and retail companies are low on capital intensity and, thus, have lower ratios.

Investors should also think about the cash flows of the companies they want to invest in. They need to see whether these particular companies have sufficient net cash inflow to pay back the debt. If the companies have an adequate amount of cash flows, then their capitalization ratio would be usually higher and vice versa. To understand this, the investors should look at a leverage ratioLeverage RatioDebt-to-equity, debt-to-capital, debt-to-assets, and debt-to-EBITDA are examples of leverage ratios that are used to determine how much debt a company has taken out against its assets or equity.read more – interest-coverage ratio.

Have a look at the ratio –

Interest-Coverage Ratio = EBIT / Interest Expense

EBIT means Earnings before interest and taxes. If we look at the Income StatementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements.read more of a company, we would be able to look at EBIT right away. This measure is used to see whether the company has enough earnings to pay off its interest or not. Along with looking at debt ratios, the investors should look at the interest coverage ratio to find out whether the company has enough earnings to pay off its interest.

Along with looking at debt ratios and interest coverage ratioInterest Coverage RatioThe interest coverage ratio indicates how many times a company's current earnings before interest and taxes can be used to pay interest on its outstanding debt. It can be used to determine a company's liquidity position by evaluating how easily it can pay interest on its outstanding debt.read more, investors should also look at the time to time, not only once or twice. To get a clear picture of where the company is in terms of capitalization, the investors should look at the figures over the period of time. Finally, they also should compare the capitalization ratios and interest coverage ratio to the peer companies to get a better understanding.

Also, look at EBIT vs. EBITDAEBIT Vs. EBITDAEBIT signifies the operating profit the company makes before the inclusion of interest and tax expenses. In comparison, EBITDA determines the company's overall operational profitability by summing the depreciation and amortization expenses to the operating profit.read more.

Capitalization Ratio Example

Now let’s look at a couple of examples to understand this ratio in detail.

Example # 1

M Corporation has furnished some information at the year-end, and from the information below, we need to understand the capitalization ratio of M Corporation from the point of view of an investor –

Details	In US $
Shareholders’ Equity	100,000
Total Debt	100,000
Short term Debt: Long term Debt	3:2

We have been given this information. Now we will find out three ratios that will help us understand this ratio of M Corporation.

Let’s start with the first ratio.

Debt-Equity Ratio = Total Debt / Shareholders’ Equity

Here, total debt is given, and we also know the shareholders’ equity.

So putting the value in the ratio, we would get Debt-Equity Ratio as –

Details	In US $
Shareholders’ Equity (A)	100,000
Total Debt (B)	100,000
Debt-Equity Ratio (B/A)	1

From the Debt-Equity Ratio, we can conclude that this is a relatively good firm that has been using both its equity and debt equally to fund its operations and expansion.

Let’s look at the next ratio.

Capitalization Ratio = Long term Debt / Capitalization

We know the total debt, and the ratio between short term and long term debt is given.

Let’s calculate the long term debt and short term debt first.

Details	In US $
Total Debt	100,000
Short term Debt: Long term Debt	3:2
Long term Debt	40,000
Short term Debt	60,000

Now, putting the value of Long term debt into ratio, we get –

Details	In US $
Shareholders’ Equity (1)	100,000
Long term Debt (2)	40,000
Capitalization (3=1+2)	140,000
Capitalization Ratio 1 (2/3)	0.285

From the above ratio, we can conclude that the ratio of M corporation is lower. If this corporation is from the IT industry, then it’s doing quite good. But if it’s from a capital intensiveCapital IntensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining.read more industries like telecommunications, utilities, etc. then M Corporation needs to improve their ratio.

Let’s look at the third ratio.

Capitalization Ratio = Total Debt / Capitalization

Here the value of capitalization would be different as we need to include total debt into the capitalization.

Details	In US $
Shareholders’ Equity (D)	100,000
Total Debt (E)	100,000
Capitalization (D+E)	200,000

Let’s put the value into the ratio.

Details	In US $
Total Debt (G)	100,000
Capitalization (F)	200,000
Capitalization Ratio 2 (G/F)	0.50

From the above ratio, we can conclude the same. If this corporation is from the IT industry, then it’s doing quite good. But if it’s from a capital intensiveCapital IntensiveCapital intensive refers to those industries or companies that require significant upfront capital investments in machinery, plant & equipment to produce goods or services in high volumes and maintain higher levels of profit margins and return on investments. Examples include oil & gas, automobiles, real estate, metals & mining.read more industries like telecommunications, utilities, etc. then M Corporation needs to improve their capitalization ratio.

Example # 2

Company C has furnished the below information –

Details	In US $
Shareholders’ Equity	300,000
Total Debt	200,000
EBIT	75,000
Interest Expenses	20,000

We need to calculate the capitalization ratio and the interest coverage ratio.

This example is important because we need to understand as an investor the role of interest coverage on the firm’s long term goals. If a firm can have enough cash to pay off the interest of its debt, then it would be in a good stance to advance; otherwise, the firm wouldn’t be able to make substantial improvements in their current standing.

Let’s Calculate the ratios.

As we have been given total debt and shareholders’ equity

Let’s calculate the capitalization.

Details	In US $
Shareholders’ Equity (1)	300,000
Total Debt (2)	200,000
Capitalization (1+2)	500,000

Putting the value of total debt and capitalization into the ratio, we get –

Details	In US $
Total Debt (3)	200,000
Capitalization (4)	500,000
Capitalization Ratio 2 (3/4)	0.40

Company C needs to improve its capitalization if it wants to succeed in the long run; however, it depends on what type of industry it is in.

Let’s calculate the interest coverage ratio now.

Interest-Coverage Ratio = EBIT / Interest Expense

Putting the value of EBIT and Interest Expense, we get –

Details	In US $
EBIT (5)	75,000
Interest Expense (4)	20,000
Interest-Coverage Ratio (5/4)	3.75

In this case, the interest-coverage ratio is quite good. That means the firm has good standing in terms of income, even if the capitalization ratio is much lower. To understand the whole picture, we need to look at all the ratios of the firm and then decide whether investing in the firm is a good idea or not.

Nestle Example

Below snapshot is Consolidated balance sheet of Nestle as of 31^st December 2014 & 2015

source: Nestle

From the table above –

• Current Portion of Debt = CHF 9,629 (2015) & CHF 8,810 (2014)
• Long Term Portion of Debt = CHF 11,601 (2015) & CHF 12,396 (2014)
• Total Debt = CHF 21,230 (2015) & CHF 21,206 (2014)

#1 – Debt to Equity Ratio

Debt to Equity Ratio = Total Debt / Total Equity

In millions of CHF	2015	2014
Total Debt (1)	21230	21206
Total Equity (2)	63986	71884
Total Debt to Equity	33.2%	29.5%

The Total Debt to Equity ratio has increased from 29.5% in 2014 to 33.2% in 2015.

#2 – Capitalization Ratio = Long Term Debt / Capitalization 

In millions of CHF	2015	2014
Long Term Debt	11601	12396
Total Debt	21230	21206
Total Equity	63986	71884
Total Debt and equity (Capitalization) (2)	85216	93090
Ratio	13.6%	13.3%

The capitalization ratio had marginally increased from 13.3% in 2014 to 13.6% in 2015.

#3 – Capitalization Ratio = Total Debt / Capitalization 

In millions of CHF	2015	2014
Total Debt (1)	21230	21206
Total Equity	63986	71884
Total Debt and equity (Capitalization) (2)	85216	93090
Ratio	24.9%	22.8%

The capitalization ratio had marginally increased from 22.8% in 2014 to 24.9% in 2015.

Analyzing Capitalization Ratio of Oil & Gas Companies (Exxon, Royal Dutch, BP & Chevron)

Below is the  (Debt to Total Capital) graph of Exxon, Royal Dutch, BP, and Chevron.

source: ycharts

We note that this ratio has increased for most of the Oil & Gas companies. This is primarily due to a slowdown in commodity (oil) prices and thereby resulting in reduced cash flows, straining their balance sheet.

Period	BP	Chevron	Royal Dutch	Exxon Mobil
31-Dec-15	35.1%	20.1%	26.4%	18.0%
31-Dec-14	31.8%	15.2%	20.9%	14.2%
31-Dec-13	27.1%	12.0%	19.8%	11.5%
31-Dec-12	29.2%	8.1%	17.8%	6.5%
31-Dec-11	28.4%	7.6%	19.0%	9.9%
31-Dec-10	32.3%	9.6%	23.0%	9.3%
31-Dec-09	25.4%	10.0%	20.4%	8.0%
31-Dec-08	26.7%	9.0%	15.5%	7.7%
31-Dec-07	24.5%	8.1%	12.7%	7.3%

source: ycharts

Important points to note here are as follows –

• Exxon ratio increased from 6.5% to 18.0% in a 3 year period.
• BP ratio increased from 28.4% to 35.1% in a 3 year period.
• Chevron ratio increased from 8.1% to 20.1% in a 3 year period.
• Royal Dutch ratio increased from 17.8% to 26.4% in a 3 year period.

Comparing Exxon with its peers, we note that the Exxon Capitalization ratio is the best. Exxon has remained resilient in this down cycle and continues to generate strong cash flows because of its high-quality reserves and management execution.

Why Marriott International Capitalization Ratio Increased Drastically – A case study

Why do you think Debt to Capital Ratio has increased drastically?

source: ycharts

Just to revisit, what is the formula of Debt to Capital Ratio = Total Debt / (Total Debt + Equity)

Did the company raise a disproportionate amount of debt?

The below image provides us with details of Marriott International Debt of 2014 and 2014. We note that debt has marginally increased. We definitely cannot blame this marginal increase in debt for the increase in Capitalization ratio.

source: Marriott International SEC Filings

Is Shareholders Equity the answer?

Did Shareholder Equity decrease? YES, it did!

Do have a look at the snapshot below of Cash flow from Financing activitiesCash Flow From Financing ActivitiesCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more of Marriott Internation. We note that the company has been buying back shares. In 2015, Marriott International bought back $1.917 billion worth treasury shares. Likewise, in 2014, it bought back $1.5 billion worth of treasury shares.

source: Marriott International SEC Filings

With this, Shareholder’s Equity reduced sharply that can be seen in the balance sheet below.

source: Marriott International SEC Filings

We note that Shareholder’s Equity was -$3.59 billion in 2015 and -2.2 billion in 2014.

Since this is a negative number, the total capital (Total Debt + Equity) reduces, thereby increasing the capitalization ratio. (Simple!)

Capitalization Ratio Video

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• DSCR Ratio

Conclusion

Capitalization ratio is helpful in understanding whether the firms have been utilizing their capital well and how. Through this ratio, we can understand how a firm leveraging its finances to create better opportunities. But as we always say, only one or two ratios are not enough to create clarity within the mind of an investor. The investor needs to look at all the ratios and net cash inflow to get a big picture of the firm before actually investing in it.