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 defined as using debt to purchase assets. Companies need to manage debt carefully, ensure enough cash flow is on hand to manage principal and interest payments. The total debt-to-capitalization ratio is calculated as:
BREAKING DOWN Total Debt-to-Capitalization Ratio
Every business uses assets to generate sales and profits, and capitalization refers to the amount of money raised to purchase assets. A business can raise money by issuing debt to creditors or by selling stock to shareholders. The amount of capital raised is reported in the long-term debt and stockholders' equity accounts in the balance sheet.
Total Debt-to-Capitalization Ratio vs. Rate of Return
Both creditors and investors want to earn a rate of return on an investment. Bondholders, for example, earn interest income on debt securities, while equity investors earn a return on equity (ROE) through dividend payments and an increase in the price of the issuer's stock. If a company takes on too much debt, it runs the risk of insolvency, which means that the issuer cannot make principal and interest payments on debt.
Examples of Capitalization
Assume, for example, 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 = ($10 million + $30 million) / ($10 million + $30 million + $60 million) = 0.4 or 40%.
This ratio indicates that 40% of the company’s capital structure consists 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 computed as follows:
Total Debt to Capitalization = ($5 million + $20 million) / ($5 million + $20 million + $15 million) = 0.625 or 62.5%.
Although XYZ has a lower dollar amount of total debt compared to ABC, $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, compared to firm ABC. The acceptable level of total debt for a company depends on the industry in which it operates. While companies in capital-intensive sectors such as utilities, pipelines, and telecommunications are typically highly leveraged, their cash flows have a greater degree of predictability than companies in other sectors that generate less consistent earnings.