What Is the Long-Term Debt to Capitalization Ratio?
A Long Term Debt to Capitalization Ratio is the debt financial leverage ratio that shows the financial leverage of the firm. It is a variation of the traditional debt-to-equity (D/E) ratio.
When dividing the long term debt with the total capital available of a company then obtained value is Long Term Debt to Capitalization Ratio. Here the total capital of the company means total long term debt plus present stock of the company.
This ratio allows the investors to spot the quantity of control utilized by an organization and compare it to other companies to investigate the entire risk experience of that specific company.
The companies which have taken more fund for capital enhancement through debts are riskier than those with lower finance debt from any lender.
High ratios indicate riskier investments, as debt is the primary source of financing and introduces a greater risk of insolvency.
When a business has a high ratio to others in their industry it can indicate that debt is the primary source of financing and that the business is on shaky ground.
This debt can be in the form of a banknote, a mortgage, debenture, or other financial obligation. The debt is recorded on the balance sheet along with its interest rate and date of maturity.
What is Long Term Debt (LTD)?
When a company holds the debt in outstanding for 12 months or more than 12 months that debt is considered as Long Term Debt (LTD). Due to longer than 12 months period it is categorized as a non-current liability on the company’s balance sheet.
The time to maturity for LTD can range anywhere from 12 months to 30+ years and the types of debt can include bonds, mortgages, bank loans, debentures, etc.
Types of Long Term Debt
There are various different types of loans can be taken in accordance with that includes.
- Bank Debt – This is any loan issued by a bank or other financial organization and isn’t tradable or transferable the way bonds are.
- Mortgages – These are loans that are backed by a specific piece of real estate, such as land and buildings.
- Bonds – These are publicly tradable securities issued by a corporation with a maturity of longer than a year.
- Debentures – These are loans that are not backed by a specific asset and, thus, rank lower than other types of debt in terms of their priority for repayment
Advantage of Long-Term Debt and Total Capitalization
- Long-term debt to capitalization ratio is a solvency gauge that shows the degree of financial leverage a company takes on.
- It calculates the proportion of long-term 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.
- This ratio allows the investors to identify the amount of control utilized by a company
- It helps in determining the financial risks that the company has taken.
Disadvantage of Long-Term Debt and Total Capitalization
- High risk is indicative of the customer’s inability to repay their debt obligations.
- It creates the risk of insolvency to the investor.
- High ratio value shows strong warning signs of financial weakness.
Formula of Long-Term Debt to Total Capitalization
The formulation of LTD to TC is as follows:
Long-Term Debt to Total Capitalization = Long-term Debt / Long-term debt + Stockholder’s Equity
When combining the long term debt, preferred stock, and common stock together, the result would be as the total capital of the company.
This is a very helpful ratio for the investors to figure out the total risk of investing in a specific business by which investors can easily understand the long term debt to capitalization ratio.
It also shows how financially the company is. This ratio helps to understand the financial risks of a particular company has taken debts.
Example of Long-Term Debt to Total Capitalization
Let’s look at the capital structure of Company XYZ. The company has a long-term debt of $70,000—$50,000 on their mortgage and the remaining $20,000 on equipment. They have assets totaling $100,000 and liabilities totaling $70,000, which results in $30,000 in stockholder equity.
Therefore, extract from above
LTD = $70,000
LTD + Stockholder’s Equity = $70,000 + $30,000 = $1,00,000
Their long-term debt to total capitalization ratio = $70,000 / $100,000 = 0 .7 (70%).
Interpretation and Analysis of Long-Term Debt to Total Capitalization
The more the ratio increases = the more debt is increasing.
This is used for the permanent financing of the company as opposed to investor funds from the sale of stock—equity financing.
However, you need to have historical data from the company or industry data to make a good comparison. As the proportion of debt increases, so does the risk of insolvency.
Conversely, a decrease in the ratio would indicate that there is an increase in stockholders’ equity.
The value of this ratio is equal to 1 show that the business has more debts than capital that is not favorable for as it can lead to several financial troubles, particularly the company getting bankrupt.
A high long term debt to capitalization ratio would indicate the financial weakness of the firm and the debt would most likely increase the risk and financial weakness of the company.
A high-value long-term debt to capitalization ratio may also raise shareholders’ return on equity because interest payments are tax-deductible. However, it also reduces a company’s financial flexibility.
A ratio of less than 1.0 indicates that the business is healthy, is not having financial difficulties, and that its debt burden is within manageable levels.
For good control over the business this ratio is very important for the business owner to ensure the business is under control and doing all things well.