Capitalization Change: What It Means, How It Works

What Is Capitalization Change?

Capitalization change refers to a modification of a company’s capital structure — the percentage of debt and equity used to finance operations and growth. Debt includes bond issues or loans, while equity mainly consists of common stock, preferred stock, and retained earnings.

KEY TAKEAWAYS

Capitalization change refers to a modification of a company’s capital structure — the percentage of debt and equity used to finance operations and growth. 

Usually, a company starts out with equity and then, as its prospects strengthen and it matures, gradually starts adding debt to its balance sheet.

Each type of capital comes with benefits and drawbacks and it is important for company management to find a suitable balance.

Investors can use capitalization ratios to measure and keep tabs on the risks associated with changes to a company’s capital structure.

How Capitalization Change Works

Companies have two main ways to raise money: debt and equity. Generally, a company starts its life with capital contributed by the founder(s), family, and friends. As the company grows, it may seek funds from venture capital investors. Any new capital injected into the business will lead to a capitalization change — simply, a greater amount of equity at this point. 

Should this company progress on a profitable path where cash flows and assets build, it would then be in a position to seek bank loans or even issue debt. The addition of debt to the balance sheet would represent another capitalization change.

As the company continues to mature, its financing needs become more sophisticated, calling for various adjustments, even transformations depending on the growth of the firm and the dynamics of the industry, to the capital structure. The issuance of new shares and assumption of debt for a large acquisition, for example, could fundamentally alter the capitalization of a company.

Capitalization changes can impact the returns companies generate for shareholders, as well as their survival prospects during recessions.

Equity vs. Debt

Each type of capital comes with benefits and drawbacks. Issuing equity is expensive, especially when interest rates are low, and dilutive, decreasing existing stockholder's ownership percentage. However, it doesn’t need to be paid back and provides extra working capital that can be used to grow a business.

Debt financing, meanwhile, offers a cheaper way to raise money, creates tax shields, and allows a business to retain ownership and not cede control. It also comes with repayment obligations, though, that if steep could cripple the company should it ever run into trouble.

Special Considerations 

The Right Balance

A responsible company strives to balance the amount of equity and debt in its capital structure according to its needs. The goal is to acquire an optimal capital structure to finance operations, maximizing a company’s market value while minimizing its cost of capital.

A company that changes its capital structure, theoretically, must keep the interests of its shareholders foremost in mind, and be careful about not taking on too much financial risk. Investors can keep tabs on these risks by using capitalization ratios: indicators that measure the proportion of debt in the capital structure. 

Capitalization Ratios

The three variants of the capitalization ratio are debt-to-equity (total debt divided by shareholders' equity), long-term debt-to-capitalization (long-term debt divided by long-term debt plus shareholders' equity) and total debt-to-capitalization (total debt divided by shareholders' equity).

What is reasonable in terms of the capitalization ratio depends on the industry and the future prospects of the company. A company, for example, could have a relatively high ratio compared to its peers, but stronger near-term profitability capacity to pay down debt and reduce the ratio to a comfortable level.

High leverage ratios are risky. However, it’s also true that aggressive capital structures can lead to higher growth rates.

By DANIEL LIBERTO Updated July 28, 2021

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