Long-Term Debt To Capitalization Ratio

What is the 'Long-Term Debt To Capitalization Ratio'

The long-term debt to capitalization ratio is a ratio showing the financial leverage of a firm, calculated by dividing long-term debt by the amount of capital available:

Long-Term Debt To Capitalization Ratio

A variation of the traditional debt-to-equity ratio, this value computes the proportion of a company's long-term debt compared to its available capital. By using this ratio, investors can identify the amount of leverage utilized by a specific company and compare it to others to help analyze the company's risk exposure as generally, companies that finance a greater portion of their capital via debt are considered riskier than those with lower leverage ratios.

BREAKING DOWN 'Long-Term Debt To Capitalization Ratio'

The choice between using long-term debt and other forms of capital, namely preferred and common stock or categorically called equity, is a balancing act to build a financing capital structure with lower cost and less risk. Long-term debt can be advantageous if a company anticipates strong growth and ample profitability that can help ensure 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 may be risky when a company already struggles with its business, and the financial strain imposed by the debt burden may well lead to insolvency.

Cost of Capital

Contrary to intuitive understanding, using long-term debt can actually help lower a company's total cost of capital. Borrowing terms are stipulated independent of a company's future business and financial performance. In other words, if a company turns out to be highly profitable, it does not need to pay the lender anything more than what the borrowing interest rate calls for and can keep the rest of the profits to itself. When a company's existing owners finance their capital with equity, they must share its available profits proportionately with all other equity holders. Although a company does not need to worry about returning capital to equity holders, the cost of using the safer equity capital is never cheap.

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 to something called debt service coverage to see by how many times total debt payments have exceeded a company's operating income or earnings before interest, tax, depreciation and amortization (EBITDA). The more that long-term debt has gone beyond EBITDA, the more uncertain if future debt payments may be fully covered. A balanced capital structure takes advantage of low-cost debt financing but also prevent the risk of a potential debt default.

RELATED TERMS
  1. Long-Term Debt

    Long-term debt consists of loans and financial obligations lasting ...
  2. Capital Structure

    A mix of a company's long-term debt, specific short-term debt, ...
  3. Capitalization Ratios

    Indicators that measure the proportion of debt in a company’s ...
  4. Leverage Ratio

    Any ratio used to calculate the financial leverage of a company ...
  5. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  6. Debt Financing

    When a firm raises money for working capital or capital expenditures ...
Related Articles
  1. Investing

    Evaluating A Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  2. Markets

    Target Corp: WACC Analysis (TGT)

    Learn about the importance of capital structure when making investment decisions, and how Target's capital structure compares against the rest of the industry.
  3. Investing

    Calculating Long-Term Debt to Total Assets Ratio

    A company’s long-term debt to total assets ratio shows the percentage of its assets that are financed with long-term debt.
  4. Investing

    Understanding Leverage Ratios

    Large amounts of debt can cause businesses to become less competitive and, in some cases, lead to default. To lower their risk, investors use a variety of leverage ratios - including the debt, ...
  5. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  6. Investing

    Total Debt to Total Assets

    Total Debt to total assets, also called the debt ratio, is an accounting measurement that shows how much of a company’s assets are funded by borrowing. In business, borrowing is also called leverage.
  7. Investing

    Will Corporate Debt Drag Your Stock Down?

    Borrowed funds can mean a leg up for companies or the boot for investors. Find out how to tell the difference.
  8. Markets

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors understand how oil and gas firms are managing their debt.
  9. Markets

    4 Leverage Ratios Used In Evaluating Energy Firms

    Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks.
  10. Markets

    Understanding Long-Term Debt

    Long-term debt is any debt or liability that is due in more than one year.
RELATED FAQS
  1. What is a good debt ratio, and what is a bad debt ratio?

  2. How can I use the debt-to-capital ratio to evaluate a stock?

    Understand the significance of the debt to capital ratio of financial leverage, and learn how investors and analysts make ... Read Answer >>
  3. Which financial ratio best reflects capital structure?

    Learn about the debt-to-equity ratio and why this metric is widely considered the most useful reflection of a company's capital ... Read Answer >>
  4. What are the different capitalization ratios?

    Learn about capitalization ratios, three different ratios that measure debt in relation to capital structure and how to calculate ... Read Answer >>
  5. Which is more important when estimating cost of capital - debt or equity?

    Learn about the relative costs of debt and equity and how they affect the overall cost of capital, including why debt may ... Read Answer >>
  6. What are the benefits and shortfalls of the Herfindahl-Hirschman Index?

    Learn about the differences between equity and debt financing and how they impact financials. Find out how businesses determine ... Read Answer >>
Hot Definitions
  1. Quantitative Trading

    Trading strategies based on quantitative analysis which rely on mathematical computations and number crunching to identify ...
  2. Bond Ladder

    A portfolio of fixed-income securities in which each security has a significantly different maturity date. The purpose of ...
  3. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  4. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  5. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  6. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
Trading Center