Long Term Debt to Capitalization Ratio

Long term debt to capitalization ratio is a variation of the debt to equity ratio. It is used to define how much financial leverage a firm has and whether its main source of funding comes from debts. When the long term debt to capitalization ratio is high, this indicates that the business may not be doing so well. It runs a higher risk of bankruptcy.

The long term debt of a company is the money the company owes in debts and loans and other ways that the payment date is not due for another twelve months from the balance sheet date. Capitalization ratio, on the other hand, is the ratio that is gotten when total debt is compared to total capitalization. Capitalization ratio is what is used as financial leverage to gauge a company’s equity. 

Long Term Debt to Capitalization Ratio Formula

\text{LTD/C} = \dfrac{\text{Long-Term Debt}}{\text{Long-Term Debt} + Common\: Stock + Preferred\: Stock}

Common stock refers to how a corporation and its ownership is divided. In this way, ownership is credited according to how many shares you hold and the worth of the company in shares as well. So, if a corporation is worth 20,000 shares then anyone having 300 shares from that company owns about 1.5 percent of that company.

Preferred stock, on the other hand, refers to a corporation’s shares that are only available to particular shareholders. They have options that are not available to people with common stocks. When we talk about long term debts,  we are referring to loans and other liabilities owed by a company that is not due in less than twelve months.

Now a combination of the common stock, long time debt and preferred stock will provide what is known as the capitalization ratio of the corporation’s total capitalization. With that, you can conclude that the higher the long term debt to capitalization ratio of a business,  the higher the financial risk run by that business.

Long term debt to capitalization ratio measures like probability which is from 0 to 1 so you are expected to get a value that is less than or equal to one but greater than zero. When it is at one, the long term debt to capitalization ratio measures to be a 100% which means 0.5 is 50%. A company with a ratio of 1.0  is 100% in debt and a company with 0.1 is only 10% in debt.

Long Term Debt to Capitalization Ratio Example

Jane just came into some money and wants to find out if she should invest in a particular mobile phone company. This mobile phone manufacturing firm owes the bank about $170 Million which is not due in the next 12 months from the day it was recorded in the balance sheet. The company also had preferred stock worth $100 Million and common stocks that are worth $150 Million. What is the long term debt to capitalization ratio of the company should she invest in them?

Let’s break it down to identify the meaning and value of the different variables in this problem.

  • Common Stock = 150M
  • Preferred Stock = 100M
  • Long Term debt = 170M

Now let’s use our formula and apply the values to our variables to calculate the long term debt to capitalization ratio:

\text{LTD/C} = \dfrac{170}{170 + 150 + 100} = 40.48\%

In this case, the long term debt to capitalization ratio would be 0.40476 or 40.48%.  This means that the company’s financial standing is quite stable. A company with long term debt to capitalization ratio of 0.5 has average financial leverage. Then, 0.4 would be higher than average. The company is about 40% in debt and Jane can invest in it. And this is promising because it is a manufacturing firm. Most manufacturing firms get their capital from debt.

Long Term Debt to Capitalization Ratio Analysis

As stated above, long term debt to capitalization ratio is the ratio of the long term debt of a business to the total capital of that business. This determines how many percent of a company’s funds come from debts or other financial liabilities. 

If a company’s long term debt to capitalization ratio is 1.0, this means that the business is 100% in debt. All its finances come from debts and it has no personal capital. So the lower the long term debt to capitalization ratio, the higher the business capital and vice versa.

This, however, does not automatically mean that the company is in trouble. Some big companies prefer to rake their capitals from debts that they eventually pay off. The only issues come when an unpredictable situation arises and they are unable to pay off the debts. This will make them more liable to bankruptcy

This value not only helps the company to evaluate its financial strength, but it also goes a long way in helping investors figure out how much risk they take on when investing in a particular business. It is also important to note that these values although reliable are not set in stone.

Long Term Debt to Capitalization Ratio Conclusion

  • The long term debt to capitalization ratio defines how much financial leverage a firm has and if its funded mainly through debt.
  • This formula requires three variables: long term debt, preferred stock, and common stock.
  • Long term debt to capitalization ratio is measured from 0 to 1 or as a percentage.

Long Term Debt to Capitalization Ratio Calculator

You can use the long term debt to capitalization ratio calculator below to quickly calculate a company’s financial leverage by entering the required numbers.