Long Term Debt to Capitalization Ratio

Definition of Long Term Debt to Capitalization Ratio

A Long Term Debt to Capitalization Ratio is the ratio that shows the financial leverage of the firm. This ratio is calculated by dividing the long term debt with the total capital available of a company. The total capital of the company includes the long term debt and the stock of the company. This ratio allows the investors to identify the amount of control utilized by a company and compare it to other companies to analyze the total risk experience of that particular company.

The companies that fund a greater portion of capital through debts are known to be riskier that those with lower finance ratios.

Formula to calculate Long Term Debt to Capitalization Ratio

The formula to calculate Long Term Debt to Capitalization Ratio is as follows:

Long term debt / (Long term debt + Preferred Stock + Common Stock)

The long term debt, preferred stock and common stock together would contribute as the total capital of the company. This is a useful ratio as it allows the investors to figure out the total risk of investing in a particular business, which can be easily determined by the long term debt to capitalization ratio. It also shows how financially the company is. This formula helps in determining the financial risks that the company has taken.

If the percentage is higher, it means that the finance of the company mainly comes from the debt which can be quite risky and is sometimes a reason for bankruptcy. The higher ratio percentage shows how weak the company is financially. Similarly, a decrease in the long term debt to capitalization ratio would mean that there is an increase in the stock holder’s equity.

A long term debt to capitalization ratio which is greater than 1.0 indicates that the business has more debts than capital which is not a good thing for a business as it can lead to lots of financial problems, especially 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 of the company.

The company should make sure that their long term debt to capitalization ratio is controlled so that their debt is under control. An out of hand debt would create problems to the company as a whole. A lower long term debt to capitalization ratio indicates that the business is not having any major financial difficulties.