As a rule, the capitalization ratio is applied in cases where the conversion of net income directly into the value of a particular object is required. If necessary, its calculation takes into account the following factors:
- net profit created and received from the operation of any object;
- funds allocated for the acquisition of this facility. An indicator that reflects the relationship between these two parameters is called the capitalization rate; the term general capitalization coefficient is also used in the economic literature. In this case, the value of the net income that is involved in the calculation of the coefficient under consideration is taken for any specific period, most often for one year.
The total capitalization ratio demonstrates the interaction between the parameters of net income, which are calculated for the year, and the market value of this particular object. In the case when this coefficient is considered more broadly, it adequately shows the ratio of the income of the enterprise in relation to the predicted value of this enterprise in the market. Thus, it turns out that this ratio is inversely proportional to the length of the payback period of the funds that are invested in this object. Metrically, it represents the percentage of net income, calculated as the average for the year, brought by those investments that were used as investments in this object.
In addition to this value, the capitalization ratio can be used as a very accurate indicator of the effectiveness of the financial activity of the enterprise and its financial stability. In this context, this ratio reflects the ratio of accounts payable to generalized indicators of amounts from all sources of financing. In this case, they include the equity of the enterprise. This ratio makes it possible to correctly assess the amount of capital the company has and establish its sufficiency or insufficiency for financing any activity as equity.
In this sense, this ratio is included in the list of so-called financial leverage indicators, that is, those that reflect the relationship between borrowed funds and the company's own capital. It also acts as an indicator of the degree of economic risk: for large values of the coefficient, there is a higher degree of dependence of an enterprise or company on borrowed funds, and as a logical consequence - lower financial stability in response to market challenges. And, accordingly, on the contrary, the larger the coefficient, the higher the return on equity is higher, and financial stability in the market is higher. In this case, the capitalization ratio is calculated as the quotient of dividing the amount of long-term liabilities of the enterprise by the amount of equity plus long-term liabilities.
As an element of financial leverage, the capitalization ratio also shows the structure of sources that can act as factors in its long-term financing. In this case, it is necessary to distinguish the company's capitalization from market capitalization, here it acts as the sum of two liabilities with high stability - long-term liabilities and equity.
The normal value of the coefficient is not established by any regulatory act or other directive method, because it is almost impossible to do this because of the large number of uncertain and random factors that affect the value of the coefficient. But as practice shows, investors are more interested in enterprises and organizations in which their own capital in size prevails over the amount of borrowed funds. However, this observation should not be absolutized, since the use of only one's own capital can significantly reduce the profit from the investments of owners.