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:

Total debt-to-capitalization ratio

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.

RELATED TERMS
  1. Debt-To-Capital Ratio

    Debt-to-capital ratio is a measurement of a company's financial ...
  2. Debt Service

    Debt service is the cash that is required for a particular time ...
  3. Leverage Ratio

    A leverage ratio is any one of several financial measurements ...
  4. Long-Term Debt To Total Assets ...

    The long-term debt to total assets ratio is a measurement representing ...
  5. Long-Term Debt to Capitalization ...

    The long-term debt to capitalization ratio, calculated by dividing ...
  6. Net Debt

    Net debt is a metric that shows a company's overall debt situation ...
Related Articles
  1. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors evaluate how energy manage their debt.
  2. 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 ...
  3. Investing

    Analyzing Oracle's Debt Ratios in 2016 (ORCL, SAP)

    Learn how the debt ratio, debt-to-equity ratio and debt-to-capital ratio are used to evaluate Oracle Corp.'s liabilities, equity and assets.
  4. Investing

    Evaluating a Company's Capital Structure

    Learn to use the composition of debt and equity to evaluate balance sheet strength.
  5. Investing

    Wal-Mart Stock: Capital Structure Analysis (WMT)

    Analyze Wal-Mart's capital structure to determine the relative contribution of debt and equity to financing the retailer's operations.
  6. Investing

    Chevron Stock: Capital Structure Analysis (CVX)

    Learn the nuances of multiple metrics that measure a firm's equity and debt capitalization, while determining Chevron's own capital structure.
  7. Investing

    AMD Stock: Capital Structure Analysis

    Analyze AMD's debt and shareholder equity to understand the firm's capital structure. Learn about shareholder deficit and high financial leverage.
RELATED FAQS
  1. What are some strategies companies commonly use to reduce their debt-to-capital ratio?

    Explore the different strategies that companies can employ and steps that can be taken to reduce a company's debt-to-capital ... Read Answer >>
  2. Why would a company use a form of long-term debt to capitalize operations versus ...

    Learn about the different consequences of using long-term debt versus equity to raise capital for business activity, and ... Read Answer >>
  3. How do I calculate the debt to equity ratio in Excel?

    Understand the basics of the debt to equity ratio, how it is interpreted as a measure of financial stability, and how it ... Read Answer >>
  4. Does working capital include short-term debt?

    Learn about a company's working capital and how short-term debt is considered part of current liabilities and is included ... Read Answer >>
Trading Center