What is capitalization?

Capitalization means different things depending on how you use the word. When talking about companies and money, capitalization usually refers to one of three things:

Company’s capital structure

The first meaning of capitalization is about how much money a company has and where that money comes from. Every company needs some amount of money to get started and keep running. This money is called the company’s capital.

A company’s capitalization shows how much capital it has and whether that capital comes from the company’s owners or from borrowing money. You can see a company’s capitalization by looking at its balance sheet. The balance sheet lists all the money the company has (its assets), all the money it owes (its liabilities), and the money that belongs to the owners (their equity).

Recording costs over time

The second meaning of capitalization is an accounting method. In accounting, capitalization means recording a cost as an investment instead of an expense.

Here’s the difference: An expense is money a company spends in a short period of time, like a month or a year. The company records the whole expense right away and it lowers the company’s earnings for that period. An investment is money the company spends on something it will use for a long time, like equipment or buildings. The company records the cost as an asset on its balance sheet. Then, over several years, the company slowly records parts of the cost as depreciation expenses. This allows the company to spread the cost over the time it expects to use the asset.

Stock market value

The third meaning of capitalization is about a company’s value in the stock market. This is also called market capitalization. To calculate a company’s market capitalization, you multiply the total number of shares of the company’s stock by the current price of one share.

For example, if a company has issued 10 million shares of stock, and each share is currently worth $50, then the company’s market capitalization is 10 million times $50, or $500 million. Market capitalization shows what investors think the whole company is worth based on the stock price.

Why capitalization matters

Evaluating financial health

A company’s capitalization tells you a lot about its financial situation and how risky it might be as an investment.

Looking at a company’s balance sheet, you can see if it has a lot of debt compared to its assets and equity. If a big portion of the company’s capital comes from borrowing, that means the company has to pay a lot of interest. It might have trouble paying its debts if business slows down. But if most of the company’s capital comes from assets and investors’ equity, the company is probably in a stronger financial position.

Comparing companies

You can also use capitalization to compare different companies, even if they’re in different industries. Market capitalization shows the total value of a company’s outstanding shares. Investors often use market capitalization to group companies by size.

For example, a large-cap stock means the company has a market capitalization of more than $10 billion. Mid-cap stocks have market caps between $2 billion and $10 billion. Small-cap stocks have market caps between $300 million and $2 billion. These categories help investors choose stocks that fit their investment strategies.

Making investment decisions

Deciding whether to treat a cost as an expense or an investment can have a big impact on a company’s financial statements. Expensing a cost lowers the company’s reported earnings for that period. Capitalizing a cost and depreciating it over time results in higher reported earnings at first, but more expenses in later years.

Managers have to be careful about these decisions. Capitalizing too many costs can make a company’s earnings look better than they really are. Investors need to understand how a company capitalizes its costs so they can get an accurate picture of the company’s performance and value.

Examples of capitalization

Buying equipment

Let’s say a construction company buys a new bulldozer for $200,000. The company expects to use the bulldozer for the next five years. The company could treat the $200,000 as an expense in the year it buys the bulldozer. This would lower the company’s earnings by $200,000 that year.

Instead, the company capitalizes the cost of the bulldozer. It records the $200,000 as an asset on its balance sheet. Then, each year for the next five years, the company records $40,000 of depreciation expense. This way, the expense is spread out over the useful life of the bulldozer.

Developing software

A software company spends $1 million developing a new application. The company plans to sell the application to customers for the next three years. The company could record the entire $1 million as an expense in the year it develops the software.

But the company decides to capitalize the development costs. It records the $1 million as an intangible asset on its balance sheet. Then it amortizes the cost over the three years it expects to sell the software. Each year, it records $333,333 of amortization expense. Like depreciation, amortization spreads the cost of an intangible asset over its useful life.

Stock market valuation

A publicly traded restaurant chain has 50 million shares of stock outstanding. The current market price of the stock is $40 per share. To calculate the company’s market capitalization, multiply the number of shares by the stock price. 50 million shares times $40 per share equals $2 billion.

With a $2 billion market capitalization, this company would be considered a mid-cap stock. Investors who want to invest in medium-sized companies might consider buying this stock as part of their investment strategy.