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. For example, 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.
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:
- Long-term debt to equity ratio
- Debt to equity ratio
Ancillary ratios that may accompany these ratios are the debt service coverage ratio and the interest coverage ratio, which are used to see if a business has sufficient cash flow to make its ongoing debt payments.