Total Debt-to-Capitalization Ratio
What Is the Total Debt-to-Capitalization Ratio?
The total debt-to-capitalization ratio is a tool that measures the total amount of outstanding company debt as a percentage of the firm's total capitalization. The ratio is an indicator of the company's leverage, which is debt used to purchase assets.
Companies with higher debt must oversee it carefully, guaranteeing sufficient cash flow is available to oversee principal and interest payments on debt. Higher debt as a percentage of total capital means a company has a higher risk of insolvency.
The Formula for the Total Debt-to-Capitalization Ratio Is
What Does the Total Debt-to-Capitalization Ratio Tell You?
Each business uses assets to create sales and profits, and capitalization alludes to the amount of money raised to purchase assets. A business can raise money by giving debt to creditors or by selling stock to shareholders. You can see the amount of capital raised as reported in the long-term debt and stockholders' equity accounts on a company's balance sheet.
Instances of the Total Debt-to-Capitalization Ratio being used
Accept, for instance, that company ABC has short-term debt of $10 million, long-term debt of $30 million and shareholders' equity of $60 million. The company's debt-to-capitalization ratio is calculated as follows:
Total debt-to-capitalization ratio:
This ratio demonstrates that 40% of the company's capital structure comprises of debt.
Consider the capital structure of another company, XYZ, which has short-term debt of $5 million, long-term debt of $20 million and shareholders' equity of $15 million. The firm's debt-to-capitalization ratio would be registered as follows:
Total debt to capitalization:
In spite of the fact that XYZ has a lower dollar amount of total debt compared to ABC, $25 million versus $40 million, debt comprises an essentially bigger part of its capital structure. In the event of an economic downturn, XYZ might struggle with making the interest payments on its debt, compared to firm ABC.
The acceptable level of total debt for a company relies upon the industry in which it works. While companies in capital-concentrated sectors like utilities, pipelines, and telecommunications are ordinarily profoundly leveraged, their cash flows have a greater degree of consistency than companies in different sectors that produce less predictable earnings.
Features
- A higher ratio result means that a company is all the more profoundly leveraged, which conveys a higher risk of insolvency.
- The total debt to capitalization ratio is a solvency measure that shows the extent of debt a company uses to finance its assets, relative to the amount of equity used for a similar purpose.
