Long-Term Debt to Capitalization Ratio
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.
Understanding Long-Term Debt to Capitalization Ratio
To achieve a balanced capital structure, firms must analyze whether utilizing 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 in the event that a company anticipates strong growth and ample profits permitting on-time debt repayments. Lenders collect just their due interest and do not participate in that frame of mind among equity holders, making debt financing sometimes a preferred funding source. Then again, long-term debt can impose great financial stress on striving companies and conceivably lead to insolvency.
Long-Term Debt and Cost of Capital
As opposed to intuitive understanding, utilizing 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 simply 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 might be the best solution for some 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 might increase financing risk. Long-term debt is often compared with debt service coverage to see how frequently 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.
Highlights
- A higher ratio result means that a company is more highly leveraged, which carries a higher risk of insolvency.
- It calculates the extent of long-term debt a company uses to finance its assets, relative to the amount of equity used for the same purpose.
- Long-term debt to capitalization ratio is a solvency measure that shows the degree of financial leverage a firm takes on.
