What Is the Long-Term Debt to Capitalization Ratio?
The long-term debt to capitalization ratio, a variation of the traditional debt-to-equity (D/E) ratio, shows the financial leverage of a firm.It is calculated by dividing long-term debt by total available capital (long-term debt, preferred stock, and common stock).Investors compare the financial leverage of firms to analyze the associated investment risk.High ratios indicate riskier investments, as debt is the primary source of financing and introduces a greater risk of insolvency.
Key Takeaways
Long-term debt to capitalization ratio is a solvency measure that shows the degree of financial leverage a firm takes on.
It calculates the proportion of long-term debt a company uses to finance its assets, relative to the amount of equity used for the same purpose.
A higher ratio result means that a company is more highly leveraged, which carries a higher risk of insolvency.
Understanding Long-Term Debt to Capitalization Ratio
To achieve a balanced capital structure, firms must analyze whether using debt, equity (stock), or both is feasible and suitable for their business.Financial leverage is a metric that shows how much a company uses debt to finance its operations. A company with a high level of leverage needs profits and revenue that are high enough to compensate for the additional debt they show on their balance sheet.
Long-term debt can be beneficial if a company anticipates strong growth and ample profits permitting on-time debt repayments. Lenders collect only their due interest and do not participate in profit sharing among equity holders, making debt financing sometimes a preferred funding source. On the other hand, long-term debt can impose great financial strain on struggling companies and possibly lead to insolvency.
Long-Term Debt and Cost of Capital
Contrary to intuitive understanding, using long-term debt can help lower a company's total cost of capital. Lenders establish terms that are not predicated on the borrower's financial performance; therefore, they are only entitled to what is due according to the agreement (e.g., principal and interest). When a company finances with equity, it must share profits proportionately with equity holders, commonly referred to as shareholders. Financing with equity appears attractive and may be the best solution for many companies; however, it is quite an expensive endeavor.
Financing Risk
When the amount of long-term debt relative to the sum of all capital has become a dominant funding source, it may increase financing risk. Long-term debt is often compared with debt service coverage to see how many times total debt payments have exceeded a company's operating income or earnings before interest, tax, depreciation, and amortization (EBITDA).Uncertainty increases that future debts will be covered when total debt payments frequently exceed operating income. A balanced capital structure takes advantage of low-cost debt financing.
Long-term debt is debt that matures in more than one year and is often treated differently from short-term debt. For an issuer, long-term debt is a liability that must be repaid while owners of debt (e.g., bonds) account for them as assets.
to capitalization ratio, a variation of the traditional debt-to-equity (D/E) ratio, shows the financial leverage of a firm. It is calculated by dividing long-term debt by total available capital (long-term debt, preferred stock, and common stock).
The long-term debt to total capitalization ratio is calculated by dividing long-term debt by the total available capital (sum of long-term debt plus shareholder's equity).
The debt-to-capital ratio (D/C ratio) measures the financial leverage of a company by comparing its total liabilities to total capital. In other words, the debt-to-capital ratio formula measures the proportion of debt that a business uses to fund its ongoing operations as compared with capital.
Long Term Debt Ratio = Long Term Debt ÷ Total Assets
The sum of all financial obligations with maturities exceeding twelve months, including the current portion of LTD, is divided by a company's total assets.
A debt ratio measures the amount of leverage used by a company in terms of total debt to total assets. This ratio varies widely across industries, such that capital-intensive businesses tend to have much higher debt ratios than others. A company's debt ratio can be calculated by dividing total debt by total assets.
Capitalization ratios include the debt-equity ratio, long-term debt to capitalization ratio, and total debt to capitalization ratio. The formula for each of these ratios is: Debt-Equity ratio = Total Debt / Shareholders' Equity. Long-term Debt to Capitalization = Long-Term Debt / (Long-Term Debt + Shareholders' Equity)
Cash-flow analysis: The debt-to-capital ratio may help determine if your business can pay off the loans' interest and still have money left over for further expenditures like R&D or acquisitions.
If the ratio is over 1, a company has more debt than assets. If the ratio is below 1, the company has more assets than debt. Broadly speaking, ratios of 60% (0.6) or more are considered high, while ratios of 40% (0.4) or less are considered low.
How to calculate your debt-to-income ratio. Your debt-to-income ratio (DTI) compares how much you owe each month to how much you earn. Specifically, it's the percentage of your gross monthly income (before taxes) that goes towards payments for rent, mortgage, credit cards, or other debt.
According to HubSpot, a good debt-to-equity ratio sits somewhere between 1 and 1.5, indicating that a company has a pretty even mix of debt and equity. A debt to total capital ratio above 0.6 usually means that a business has significantly more debt than equity.
If a company has $100,000 in total assets with $40,000 in long-term debt, its long-term debt-to-total-assets ratio is $40,000/$100,000 = 0.4, or 40%. This ratio indicates that the company has 40 cents of long-term debt for each dollar it has in assets.
In general, a ratio around 0.3 to 0.6 is where many investors will feel comfortable, though a company's specific situation may yield different results.
To calculate your DTI, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
A debt-to-income, or DTI, ratio is derived by dividing your monthly debt payments by your monthly gross income. The ratio is expressed as a percentage, and lenders use it to determine how well you manage monthly debts -- and if you can afford to repay a loan.
If a company has $100,000 in total assets with $40,000 in long-term debt, its long-term debt-to-total-assets ratio is $40,000/$100,000 = 0.4, or 40%. This ratio indicates that the company has 40 cents of long-term debt for each dollar it has in assets.
The total debt-to-total assets ratio is calculated by dividing a company's total debt by its total assets. This ratio shows the degree to which a company has used debt to finance its assets. The calculation considers all of the company's debt, not just loans and bonds payable, and all assets, including intangibles.
The optimal debt-to-equity ratio will tend to vary widely by industry, but the general consensus is that it should not be above a level of 2.0. While some very large companies in fixed asset-heavy industries (such as mining or manufacturing) may have ratios higher than 2, these are the exception rather than the rule.
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