Total Debt-to-Capitalization Ratio

What is the 'Total Debt-to-Capitalization Ratio'

The total debt-to-capitalization ratio is an indicator that measures the total amount of debt in a company’s capital structure. The total-debt-to-capitalization ratio is a gauge of a company’s financial leverage, and is calculated as:

Leverage can be a double-edged sword for a company. While a high total-debt-to-capitalization ratio can increase shareholders’ return on equity because of the tax deductibility of interest payments, a higher proportion of debt reduces a company’s financial flexibility and increases the risk of insolvency. A lower debt-to-capitalization ratio may be preferable for most companies in order to keep the debt burden within easily manageable levels.

BREAKING DOWN 'Total Debt-to-Capitalization Ratio'

For example, consider company ABC with short-term debt of $10 million, long-term debt of $30 million, and shareholders’ equity of $60 million. The company’s total-debt-to-capitalization ratio would be computed as follows:

Total Debt to Capitalization = ($10 + 30) / ($10 + $30 + $60) = 0.4 or 40%.

This ratio indicates that 40% of the company’s capital structure consists of debt.

Now consider the capital structure of company XYZ, which has short-term debt of $5 million, long-term debt of $20 million, and shareholders’ equity of $15 million. Its total-debt-to-capitalization ratio would be computed as follows:

Total Debt to Capitalization = ($5 + 20) / ($5 + $20 + $15) = 0.625 or 62.5%.

Thus, although XYZ has a lower absolute level of total debt ($25 million versus $40 million), debt comprises a significantly larger part of its capital structure. In the event of an economic downturn, XYZ may have a difficult time making the interest payments on its debt.  

The acceptable level of total debt for a company depends on the industry in which it operates. While companies in capital-intensive sectors like utilities, pipelines, and telecommunications are typically highly leveraged, their cash flows have a greater degree of predictability than companies in other sectors that are exposed to the economy’s cyclical fluctuations.

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