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

https://www.investopedia.com/terms/c/capitalization-change.asp#:~:text=Capitalization%20change%20refers%20to%20a,preferred%20stock%2C%20and%20retained%20earnings.

What is the Importance of Capital Structure?

The importance of capital structure is as follows:

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• Increase in the value of the firm

A proper capital structure of a company helps in increasing the market price of the shares and securities that, in turn, will lead to an increase in the value of the company.

• Utilizing the available funds

An organized capital structure permits a business to utilize the available funds completely. An appropriately planned capital structure guarantees the assurance of the money related necessities of the firm and raises the assets in such extents from different hotspots for their most ideal use. A sound capital structure shields the business venture from over-capitalization and under-capitalization.

• Maximization of return

A sound capital structure empowers the board to expand the benefits of an organization as better yield to the value investors, i.e., increment in income per share. This should be possible by the system of exchanging on value, i.e., it alludes to increment in the extent of obligation capital in the capital structure, which is the least expensive wellspring of capital. In the event that the pace of profit for capital utilized surpasses the fixed pace of premium paid to obligation holders, the organization is supposed to exchange on value.

• Minimizing the cost of capital

A sound capital structure of any business undertaking expands investors' riches through the minimization of the usual expense of capital. This must likewise be possible by joining long term debt capital in the capital structure as the expense of debt capital is lower than the expense of value or inclination share capital since the enthusiasm on the obligation is charge deductible.

• Solvency or Liquidity position

A proper capital structure will never allow a business to go for too much raising of debt capital because, during the time of poor earning, the solvency is disturbed for mandatory payment of interest to the supplier of debt.

• Flexibility

A proper capital structure gives room for expansion or reduction of the debt capital so that, as per the changing conditions, the adjustment of capital can be made.

• Undisturbed controlling

A better capital structure does not permit the equity shareholders' control on business that is to be diluted.

• Minimization of financial risk

In the event that obligation part increments in the capital structure of an organization, the budgetary hazard will likewise increment. A sound capital structure shields a business endeavour from such monetary hazard through a wise blend of obligation and value in the capital structure.

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.

The capital structure in a firm is generally expressed as debt to equity or debt to capital ratio.  The total amount of debt or equity employed by a firm to fund the operations and finance the assets in a business. 

To fund the business’s operations, acquisition, and other investments, organizations use debt and equity capital. Companies need to look at tradeoffs and then decide whether they need to use the debit or equity to finance the operations. The managers balance the two to check the optimal capital structure.

Capitalization

Capitalization in Finance

In finance, capitalization is the sum of a company’s debt and equity. It represents the capital invested in the company, including bonds and stocks. 

Capitalization can also mean market capitalization. Market capitalization is the value of a company’s outstanding shares of stock and it represents the value of the firm according to investors’ perceptions. It is equal to the number of shares outstanding multiplied by the share price.

Market Capitalization = Shares Outstanding x Share Price

Capitalization in Accounting

In accounting, capitalization refers to recording costs as assets on the balance sheet instead of as expenses on the income statement. A company may record the purchase price of an asset, as well as the asset’s acquisition costs, such as transportation and setup, as assets on the balance sheet.

Capitalization also refers to transferring an off-balance-sheet operating lease onto the balance sheet and recording it as a capital lease. To do this, calculate the present value of the future operating lease payments and record the amount on the balance sheet as an asset with a corresponding liability. 
Capitalization of Cost

For example, a manufacturing company may record the cost of raw materials, direct labor, and overhead as assets – where labor and overhead would be capitalized costs. The assets (including the capitalized costs) are then transferred to the income statement as costs of goods sold as the underlying assets are sold to customers. Capitalizing costs increases the value of total assets and equity on the balance sheet, as well as net income on the income statement. 


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SPG guide on capitalisation changes

Internal capitalisation changes are those capitalisation changes which affect the number of shares held by the pre-existing shareholders (i.e. bonus, rights, splits, etc.).

Shares issued to outsiders in the case of share swaps, special issues, etc., do not affect the number of shares held by the pre-existing shareholders.

SPG does not believe that bonuses increase the value of shares, and advise investors not to pay much attention to the past number of bonus issues.

We look at rights in another light, however, as we are not in favour of rights issues unless the company has been an exceptionally fast growing ones (i.e. growth in excess of 20% per year). In other cases, a company which has issued more than one rights in the past decade ought to be viewed with caution.

It is perhaps worth pointing out that a company which has many capitalisation changes all bunched together during a short space of time without a concomitant increase in earnings could be trying to impress its sharehodlers and the stockmarket. Historically, such companies usually performed poorly after such capitalisation changes were over.

Any existing issues which will lead to future dilution should be noted. Dilution means the creation of extra number of shares which will cause the per share earnings and dividend to decline. Normally, dilutive issues include warrants (TSR) and convertibles. By comparing the number of new shares which will be issued with the existing number of shares, the user would have an idea of the potential dilution.

For example, if a total of 100 million new shares will be issued and the exisitng number of shares is 300 million; the potential earnings dilution would be 25% without taking into consideration the notional interest saving. That is the EPS will decline, say, from 10 sen per share to 7.5 sen.

Fixed income securities (i.e. bonds etc) issued by the company should be considered too.


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How to use the Stock Performance Guide (SPG)
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