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.

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