Long-Term Debt to Capitalization Ratio

Long-Term Debt to Capitalization Ratio

What is the long-term debt / capitalization ratio?

The long-term debt-to-capitalization ratio, a variation of the traditional debt-to-equity ratio, shows a company’s financial leverage. It is calculated by dividing long-term debt by total available capital (long-term debt, preferred shares and common shares). Investors compare the financial leverage of companies to analyze the associated investment risk. High ratios indicate risky investments, since debt is the main source of financing.

Understanding the long-term debt / capitalization ratio

To achieve a balanced capital structure, companies need to analyze whether the use of debt, equity (stocks), or both, is feasible and appropriate for their business. Long-term debt can be beneficial if a company anticipates strong growth and sufficient profits to pay off the debt on time. Lenders receive only their interest and do not participate in the sharing of profits between shareholders, making debt financing sometimes a preferred source of financing. On the other hand, long-term debt can impose considerable financial pressure on struggling businesses and can lead to insolvency.

Cost of capital

Contrary to an intuitive understanding, using long-term debt can help reduce the total cost of capital for a business. Lenders establish conditions that are not based on the financial performance of the borrower; therefore, they are only entitled to what is due under the agreement (for example, capital and interest). When a company finances with equity, it must share the profits proportionally with the shareholders, commonly called shareholders. Equity financing looks attractive and may be the best solution for many businesses; however, it is a fairly expensive undertaking.

Financing risk

When the amount of long-term debt relative to the sum of all capital has become a dominant source of funding, it can increase the risk of funding. Long-term debt is often compared to debt service coverage to see how many times total debt payments have exceeded operating profit or profit before interest, taxes, and amortization (EBITDA) by business. Uncertainty increases that future debts will be covered when the total payment of the debt frequently exceeds the operating result. A balanced capital structure benefits from low cost debt financing.

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