## 3.3. Capitalization ratio

Capitalization ratio shows what portion of a company’s capital (debt and equity) is represented by debt. This ratio is calculated by dividing long-term (non-current) liabilities by the sum of long-term liabilities and equity. This ratio describes the capital structure of the company.

Note that there may be variations of what is included in debt (denominator) in the capitalization ratio formula. Sometimes debt includes both current liabilities and long-term debt (i.e., total liabilities). In this tutorial, for simplicity we will assume that only long-term debt is included in the denominator.

The higher the capitalization ratio is, the riskier the company is, and on the contrary, the lower the capitalization ratio is, the less risky the company is. Capitalization ratio varies depending on industry, company’s stage of development, and so on.

Capitalization Ratio Formula

Capitalization ratio is calculated by dividing long-term debt by the sum of long-term liabilities and total equity:

 Capitalization Ratio = Long-term Liabilities Long-term Liabilities + Shareholder’s Equity

Capitalization Ratio Example

Let’s return to our example of Friends Corporation. The capitalization ratio at the end of fiscal year 20X9 was:

 Capitalization Ratio = \$3,220 = 0.149 (rounded) \$3,220 + \$18,350

Capitalization ratio of 0.149 means that 14.9% of the company’s capital is represented by long-term debt, which is not too high. Therefore, the company is not so risky in terms of the capitalization ratio.

Important Notes

• When evaluating capitalization ratios, it is important to consider that a company with a high capitalization ratio may have hard times repaying debt or obtaining additional loans. On the other hand, a company with a very low capitalization ratio may not be risky, but it may have conservative management (which is not using opportunities for the company’s growth through long-term borrowings) and therefore provides lower earnings to its shareholders.
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