Investors should use different types of financial ratios to determine the health of a company. However, the key financial indicators you use will depend on what aspect of the company you are interested in investigating.
For example, if you are risk-averse and prefer a company with minimal external debt, it would be wise to calculate the equity to total capitalization ratio of the companies you want to invest in. And then, you can compare those companies to their competitors within similar industries.
What Is the Equity to Total Capitalization Ratio?
The equity to total capitalization ratio refers to the ratio of the shareholders' equity in a company relative to the total capitalization of a company. It is one of the important financial metrics investors can use and is meant to measure the part of the company that is held by shareholders relative to its total long-term debt and equity. You can multiply it by 100 percent to determine the percentage of the company financing that comes from shareholders.
Generally, the lower the equity to total capitalization ratio, the more debt obligations the company has. That higher amount of debt poses a bigger risk for investors should the business face some tough times.
The summarized formula for this ratio is:
Equity to Capitalization Ratio = Stockholders’ Equity/Total Capitalization
Below is a definition breakdown for this formula.
According to the Corporate Finance Institute, stockholders' or shareholders' equity refers to the portion of the company that belongs to the shareholders. It is what would be left for and distributed to shareholders after all the debts of the company have been settled. It consists of retained earnings and the capital generated from selling shares.
You can find the stockholders’ equity within the liabilities and shareholders’ equity section of the balance sheet.
The formula for stockholders' equity is:
Shareholders' Equity = Total Assets - Assets Liabilities
Alternatively, you could use the formula:
Stockholders' Equity = Retained Earnings + Share Capital - Treasury Stock
Total capitalization refers to the sum of a company’s long-term debt and all types of equity its shareholders possess. In this case, equity may include both preferred and common stock. On the other hand, long-term debt includes corporate bonds, individual notes payable and mortgages. It is found under non-current liabilities on the balance sheet.
Total capitalization is also known as capital structure and provides information on the financing available for companies to use for growth, expansion and product development. It is different from market capitalization, or market cap, which is partly influenced by stock price and whose information is available from financial statements such as balance sheets.
According to the federal Investor.gov website, the latter refers to the total value of a company based on the prevailing market prices of its stock multiplied by outstanding shares (the total number of shares held by all shareholders). And depending on the total stock market value, a company’s size could be categorized as small-cap (between $300 million and $2 billion), mid-cap (between $2 billion and $10 billion) or large-cap (more than $10 billion).
The formula for total capitalization may be summarized as follows:
Total Capitalization = Long-Term Debt + Stockholders' Equity
Based on the definitions of total capitalization and stockholders' equity, you could break down the equity to total capitalization ratio as follows:
Equity to Capitalization Ratio = (Total Assets -Total Liabilities)/ (Long-Term Debt + (Total Assets - Total Liabilities))
Suppose you are considering investing in General Oil Ltd. A look at their balance sheets shows the company has total assets worth $5.9 million and total liabilities of $845,000. In addition, the company has long-term debts worth $750,000.
In that case, the company’s equity to total capitalization ratio will be:
($5.9 million - $845,000)/ ($750,000 + ($5.9 million-$845,000)), which equals $5,055,000/5,805,000. The resulting value is 0.87. And when you multiply it by 100 percent, you get 87 percent.
What that implies is that General Oil Ltd is a company whose activities are mostly financed by shareholders, with only 13 percent of its long-term financing coming from external debt. In the event that the company is liquidated, as an investor, you are highly likely to get most of your money back.
The equity to total capitalization ratio is one of the important values or metrics to consider when evaluating a company’s net worth. However, it is not the only ratio available. So, watch out for other key financial indicators relevant to the industry you are interested in.
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