Long-Term Debt to Capitalization Ratio: Meaning and Calculations

What Is the Long-Term Debt to Capitalization Ratio?

The long-term debt to capitalization ratio shows the financial leverage of a firm. It is calculated by dividing long-term debt by total available capital. Investors compare the financial leverage of firms to analyze investment risk. High ratios indicate riskier investments, as debt is the primary source of financing and introduces a greater risk of insolvency.

Key Takeaways

• The long-term debt to capitalization ratio measures 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 means that a company is more highly leveraged, which carries a higher risk of insolvency.

Understanding Long-Term Debt to Capitalization Ratio

Firms must analyze whether using debt, equity (stock), or both is feasible and suitable for their business. Financial leverage shows how much a company uses debt to finance its operations. A company with high leverage needs profits and revenue high enough to compensate for additional debt on their balance sheet.

Long-term debt can be beneficial if a company anticipates strong growth and ample profits allowing on-time debt repayments. Debt financing is sometimes preferred as lenders only collect their due interest and do not participate in profit sharing. However, long-term debt can impose financial strain and lead to insolvency.

Long-Term Debt and Cost of Capital

Using long-term debt can help lower a company’s total cost of capital. Lenders are entitled to what is due according to the agreement, unlike equity holders who share profits proportionately. Financing with equity is expensive.

Financing Risk

When long-term debt becomes 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 EBITDA. Uncertainty increases when total debt payments frequently exceed operating income. A balanced capital structure takes advantage of low-cost debt financing.