Long-Term Debt to Capitalization Ratio
Candlefocus EditorIn general, the higher the long-term debt to capitalization ratio, the more highly leveraged a company is. Leveraging typically results in higher returns on equity and suggests that the company is able to efficiently use borrowed funds to achieve growth. However, it also carries with it a higher risk of insolvency, especially when the debt load has become too high to service.
The long-term debt to capitalization ratio is a useful measure to gauge the ability of a company to fund its long-term debt obligations. It is calculated by dividing total long-term debt (which includes both secured and unsecured debts) by the sum of total long-term debt and shareholders’ equity. This number is expressed as a proportion and can be multiplied by 100 to present it as a percentage.
In practice, a long-term debt to capitalization ratio of less than 30% is typically preferred, indicating that the company relies more on equity than debt to finance its assets. Ratios that exceed this level may indicate that the company has become too heavily leveraged, making it vulnerable to sudden changes in economic conditions, with a greater risk of insolvency.
Therefore, the long-term debt to capitalization ratio is an important measure for investors to assess the level of financial leverage taken on by the company, the implications of which must be carefully evaluated. It is essential to note that the ratio can vary significantly between industries and across countries so investors must ensure they compare similar companies before reaching any conclusion.