Capitalization ratios
/What are Capitalization Ratios?
Capitalization ratios compare the debt and equity of a business, with the intent of determining the extent to which a firm may be over-leveraged or under-leveraged. There is no single outcome of a capitalization ratio that clearly indicates that debt levels are too high or too low. Instead, these ratio outcomes must be compared to the stability of an entity's cash flows. Thus, a business in a monopoly market with very steady cash flows could probably support a high debt load, whereas a firm operating in a competitive market with short product cycle times would probably find it risky to carry much debt at all.
Capitalization ratios can also be evaluated based on the ratio results for peer companies in the same industry. These entities tend to have similar capitalization ratios, since everyone in the industry operates within roughly the same cash flow parameters. Consequently, when the target company reports an unusually high ratio in comparison to these firms, it can be a signal that debt levels are dangerously high. Examples of capitalization ratios are noted next.
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Long-Term Debt to Equity Ratio
The long-term debt to equity ratio is a method used to determine the leverage that a business has taken on. When the ratio is comparatively high, it implies that a business is at greater risk of bankruptcy, since it may not be able to pay for the interest expense on the debt if its cash flows decline. This is more of a problem in periods when interest rates are increasing, or when the cash flows of a business are subject to a large amount of variation, or when an entity has relatively minimal cash reserves available to pay down its debt obligations. It is calculated as follows:
Long-term debt ÷ Equity = Debt to equity ratio
Debt to Equity Ratio
The debt to equity ratio measures the riskiness of a company's financial structure by comparing its total debt to its total equity. The ratio reveals the relative proportions of debt and equity financing that a business employs. It is closely monitored by lenders and creditors, since it can provide early warning that an organization is so overwhelmed by debt that it is unable to meet its payment obligations. It is calculated as follows:
(Long-term debt + Short-term debt + Leases) ÷ Equity = Debt to equity ratio
Debt Service Coverage Ratio
The debt service coverage ratio measures the ability of a revenue-producing property to pay for the cost of all related mortgage payments. In essence, it compares cash flows to debt service payments. A positive debt service ratio indicates that a property’s cash flows can cover all offsetting loan payments, whereas a negative debt service coverage ratio indicates that the owner must contribute additional funds to pay for the annual loan payments. It is calculated as follows:
Net Annual Operating Income ÷ Total of Annual Loan Payments = Debt service coverage ratio
Interest Coverage Ratio
The interest coverage ratio measures the ability of a company to pay the interest on its outstanding debt. This measurement is used by creditors, lenders, and investors to determine the risk of lending funds to a company. A high ratio indicates that a company can pay for its interest expense several times over, while a low ratio is a strong indicator that a company may default on its loan payments.
Earnings before interest and taxes ÷ Interest expense = Interest coverage ratio
Example of Capitalization Ratios
A utility with very steady cash flows can probably afford to have a high debt-equity ratio, since it is very likely that all debt payments can be made. Conversely, a small consumer electronics firm that experiences rapid product obsolescence probably cannot afford to maintain even a modest debt-equity ratio, since its cash flows are so variable.