The long-term debt to capitalization ratio shows how much financial leveraging—the use of debt to finance growth or acquire other assets—a firm has. This ratio is a variation of debt-to-equity. When a business has a high ratio to others in their industry it can indicate that debt is the primary source of financing and that the business is on shaky ground.
Understanding Long-Term Debt and Total Capitalization
Long-term debt is defined as an interest-bearing obligation owed for over 12 months from the date it was recorded on the balance sheet. This debt can be in the form of a banknote, a mortgage, debenture, or other financial obligation. The debt is recorded on the balance sheet along with its interest rate and date of maturity.
Total capitalization is the sum of long-term debt and all other types of equity, such as common stock and preferred stock. Total capitalization forms a company's capital structure and is sometimes computed as total assets minus total liabilities.
Financing With Long-Term Debt
The long-term debt to total capitalization ratio shows the extent to which long-term interest-bearing debt (such as bonds and mortgages) are used for the firm's permanent financing or the financial leverage of the company. On the flip side, it shows how much of the firm is financed by investor funds or equity. Thus, it allows investors to identify the amount of control utilized by a company and compare it to other companies to analyze the total risk experience of a particular company.
Companies that fund a greater portion of capital through debts are considered to be riskier than those with lower finance ratios.
The debt-to-asset ratio and the long-term debt to total capitalization ratio both measure the extent of a firm's financing with debt.
Calculating Long-Term Debt to Total Capitalization
The calculation of long-term debt to total capitalization is:
Long-term Debt / Long-term debt + Stockholder's Equity = ___ percent
Let's look at the capital structure of Company XYZ. The company has a long-term debt of $70,000—$50,000 on their mortgage and the remaining $20,000 on equipment. They have assets totaling $100,000 and liabilities totaling $70,000, which results in $30,000 in stockholder equity. Thus, their long-term debt to total capitalization ratio would be $70,000 / $100,000 = 0 .7 (70%).
Considerations of Debt
The more the ratio increases, the more debt is being used for the permanent financing of the firm as opposed to investor funds from the sale of stock—equity financing. However, you need to have historical data from the firm or industry data to make a frim comparison. As the proportion of debt increases, so does the risk of insolvency. Conversely, a decrease in the ratio would indicate that there is an increase in stockholders' equity.
Banks and other lending institutions review insolvency or bankruptcy risk before extending credit. High risk is indicative of the customer's inability to repay their debt obligations and the likelihood of default.
If the long-term debt to capitalization ratio is greater than 1.0, it indicates that the business has more debt than capital, which is a strong warning sign indicating financial weakness. Any further debt beyond this point would increase the company's risk.
A high long-term debt to capitalization ratio can also increase shareholders' return on equity because interest payments are tax-deductible. However, it also reduces a company's financial flexibility. A ratio of less than 1.0 indicates that the business is healthy, is not having financial difficulties, and that its debt burden is within manageable levels.
Business owners should monitor the long-term debt to capitalization ratio to ensure that it is under control as it serves as an indicator that their debt is under control.