What it means
A company's permanent capital comes from two sources, and the capitalisation ratio expresses the balance between them as a percentage of the total. It differs from the debt-to-equity ratio only in form: debt to equity of 0.67 (two parts debt to three parts equity) is the same balance sheet as a capitalisation ratio of 40% (two parts debt in five parts total).
The percentage form is often preferred because it stays between 0% and 100% and is easier to compare. The ratio's meaning depends on what is counted.
The strict version uses long-term debt only, on the reasoning that short-term borrowing funds working capital and fluctuates. A broader version uses total interest-bearing debt.
Most analysts today add lease liabilities, which are on the balance sheet under current standards and are debt in substance, and some add pension deficits and preference shares. Some net cash against debt.
Whichever version is used must be stated and applied consistently, and covenants define their own terms precisely for that reason. Interpretation is relative.
Utilities, infrastructure and property companies commonly run capitalisation ratios of 50% to 70% because their cash flows are predictable and their assets are good security. Manufacturers and retailers typically sit at 20% to 45%.
Technology and pharmaceutical companies often run below 20% or have net cash. A ratio that is high for its industry indicates greater financial risk: more of the cash flow is committed to interest and repayment, less cushion exists for a downturn, and lenders will charge more and impose tighter terms.
A ratio that is low may indicate conservatism, an inefficient balance sheet, or a business whose cash flows cannot support debt. Trend matters as much as level.
A ratio rising because the company is borrowing to invest in projects that will earn more than the interest is different from one rising because losses are eroding equity. A ratio falling because debt is being repaid from cash flow is different from one falling because the company has issued equity to survive.
The ratio should be read with interest cover (can the company service the debt from earnings) and net debt to EBITDA (how many years of cash generation would repay it). Lenders use capitalisation ratios in covenants because they are simple to calculate and hard to manipulate without changing the balance sheet.
A typical covenant might require the ratio to remain below 55%, tested quarterly. Companies manage to these limits, and the limits in turn shape financing decisions: a company near its covenant will fund an acquisition with equity or defer it, whatever the cost of capital arithmetic says.
In practice
Real-world examples.
Example
A power utility maintains a capitalisation ratio of 60% in line with its regulator's assumed structure and its rating agency's threshold for an A rating.
Example
A software company with $200 million of equity and $10 million of debt has a ratio of 4.8% and is described as effectively unleveraged.
Example
A retailer's ratio jumps from 30% to 48% when store leases are recognised on the balance sheet, prompting a renegotiation of its bank covenants.
Think of it
“Capitalization ratio shows how much of your permanent capital comes from borrowing versus owner investment.
Formula
Calculation
Capitalisation Ratio = Long-term debt / (Long-term debt + Shareholders' equity) x 100%
Total Debt to Capital = (Short-term debt + Long-term debt) / (Total debt + Shareholders' equity) x 100%
Adjusted Capitalisation Ratio = (Total debt + Lease liabilities) / (Total debt + Lease liabilities + Equity) x 100%
Worked example. A company's balance sheet shows: short-term borrowings $15,000,000; long-term bonds $120,000,000; lease liabilities $45,000,000; shareholders' equity $210,000,000; cash $25,000,000. EBITDA $60,000,000; interest expense $9,000,000; operating profit $42,000,000.
- Capitalisation ratio (long-term debt only) = $120,000,000 / ($120,000,000 + $210,000,000) = 36.4%
- Total debt to capital = $135,000,000 / ($135,000,000 + $210,000,000) = 39.1%
- Adjusted for leases = $180,000,000 / ($180,000,000 + $210,000,000) = 46.2%
- Net of cash = ($180,000,000 minus $25,000,000) / ($155,000,000 + $210,000,000) = 42.5%
- Debt to equity (total debt) = $135,000,000 / $210,000,000 = 0.64
- Net debt to EBITDA (including leases) = $155,000,000 / $60,000,000 = 2.6
- Interest cover = $42,000,000 / $9,000,000 = 4.7
The four versions of the ratio range from 36% to 46%, which illustrates why the definition must be stated. The bank covenant, defined as total debt including leases to total capital, requires less than 55%; the company is at 46.2% with headroom.
The company proposes a $60,000,000 acquisition. Funded entirely by new debt: adjusted ratio = $240,000,000 / ($240,000,000 + $210,000,000) = 53.3%, within the covenant but with little room; net debt to EBITDA would rise to 3.6 before the target's earnings. Funded half by debt and half by a share issue: ratio = $210,000,000 / ($210,000,000 + $240,000,000) = 46.7%, essentially unchanged. The board opts for the mixed funding, accepting dilution to keep the ratio inside its own policy range of 40% to 50%.
Trend check: three years ago the adjusted ratio was 38%. It has risen because lease liabilities came onto the balance sheet under the new standard (adding 6 points) and because a buyback reduced equity (adding 2 points); underlying borrowing is unchanged. The board's report explains both effects so that the rise is not read as increased risk in the business.Case study
Seen in the real world.
A construction group had a capitalisation ratio covenant of 50% in its main banking facility, defined on long-term debt and equity. Over two years it built up $40,000,000 of short-term borrowing, which the covenant did not count, to fund working capital on large contracts, while its long-term ratio stayed at 44%. The bank's annual review looked at total debt and found the true leverage was 58%.
The facility was renegotiated with the covenant redefined to include all borrowings and lease liabilities, the margin increased by 0.75%, and a requirement added for quarterly reporting of the full ratio. The group's finance director, who had regarded the short-term borrowing as temporary, discovered that it had become permanent as the contract book grew, and that its cost had risen with every renewal.
He converted $30,000,000 of it into a five-year term loan, which raised the reported long-term ratio to 52% under the old definition but reduced the group's true refinancing risk, and set an internal limit on the all-in ratio at 50% with a warning at 45%. The board's lesson was that a ratio defined narrowly could be met while the risk it was meant to measure grew outside the definition, and that the group should track the measure the bank cared about, not the one in the document.
Watch out
Common mistakes.
- Comparing capitalisation ratios calculated on different definitions (with or without short-term debt, leases, cash), which can differ by ten points or more.
- Judging a ratio without reference to the industry, where normal levels range from near zero to over 60%.
- Reading the ratio alone. It shows the balance of funding but not whether the company can service the debt; pair it with interest cover and net debt to EBITDA.
Questions
People also ask.
What is a good capitalisation ratio?
For most industrial companies, below 40% to 50%; for utilities and property, higher levels are normal; for companies with volatile earnings, lower. Compare with peers and with the company's own trend.
How does the capitalisation ratio differ from the debt-to-equity ratio?
They express the same balance sheet differently: capitalisation ratio is debt as a share of debt plus equity; debt to equity is debt divided by equity alone. A capitalisation ratio of 50% equals a debt-to-equity ratio of 1.0.
Should preference shares count as debt?
For a fixed-dividend, redeemable preference share, many analysts and rating agencies count it partly or wholly as debt. Perpetual, non-cumulative preference shares are closer to equity.
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