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 manage it carefully, ensuring enough cash flow is on hand to manage 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
Total debt to capitalization=(SD+LTD+SE)(SD+LTD)where:SD=short-term debtLTD=long-term debtSE=shareholders’ equity
What Does the Total Debt-to-Capitalization Ratio Tell You?
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. 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.
- The total debt to capitalization ratio is a solvency measure that shows the proportion of debt a company uses to finance its assets, relative to the amount of equity used for the same purpose.
- A higher ratio result means that a company is more highly leveraged, which carries a higher risk of insolvency.
Examples of the Total Debt-to-Capitalization Ratio in Use
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 mill.+$30 mill.+$60 mill.)($10 mill.+$30 mill.)=0.4=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 mill.+$20 mill.+$15 mill.)($5 mill.+$20 mill.)=0.625=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.