This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
Assuming that the operating ratio of a company is not far from normal in its line, a fairly definite relation may be sometimes established between gross earnings and stock and bond issues. In the chapter on capitalization (Chapter VIII) it has been suggested that industrial companies frequently show a total capitalization approximately equal to their gross earnings. This relation may easily exist wherever the percentage of profit on sales is about equivalent to the percentage of profit expected on capital invested in that industry. Inasmuch as companies which carry on a business that involves considerable fluctuations and risks expect a high percentage of profit both on sales and on capital invested, it is clear that the correspondence between gross earnings and capitalization is not purely accidental.
Wherever the operating ratio, however, leaves a margin of profit on sales that is either much higher or much lower than the expected rate on invested capital, this relation of equality between gross earnings and capitalization will not exist, but will be supplanted by some other fairly stable ratio. Companies which do a large business on a small margin - commission houses, retail stores, manufacturers of staples, and the like - will customarily have a capitalization much smaller than gross sales. Companies like railroads, interurban lines, and public utilities, which have a low operating ratio, will customarily have a capitalization of several times their gross earnings. Electric street railway companies normally have a capitalization of four to six times gross earnings. A little figuring based on the normal operating ratio and the normal relations of gross earnings to capitalization in any given line of industry, will often prove an exceedingly helpful method of testing in a rough way the capitalization that will be proper for a given enterprise.