What Is the Total Debt-to-Capitalization Ratio?
Let me explain the total debt-to-capitalization ratio directly: it's a tool that measures the total amount of a company's outstanding debt as a percentage of its total capitalization. This ratio shows you the level of leverage, which is essentially debt used to buy assets.
If a company has higher debt, you need to manage it carefully. Make sure there's enough cash flow to handle principal and interest payments. A higher debt percentage in total capital increases the risk of insolvency— that's the straightforward risk you're looking at.
The Formula for the Total Debt-to-Capitalization Ratio
Here's the formula you use: Total debt to capitalization equals (short-term debt + long-term debt) divided by (short-term debt + long-term debt + shareholders' equity). That's it—SD for short-term debt, LTD for long-term debt, and SE for shareholders' equity.
What Does the Total Debt-to-Capitalization Ratio Tell You?
Every business needs assets to generate sales and profits, and capitalization is the money raised to purchase those assets. You can raise money by issuing debt to creditors or selling stock to shareholders. Check the long-term debt and stockholders' equity on the balance sheet to see this.
This ratio is a solvency measure showing how much debt finances assets compared to equity. A higher ratio means the company is more leveraged, which brings a higher risk of insolvency.
Key Takeaways
- The total debt to capitalization ratio is a solvency measure that shows the proportion of 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.
Examples of the Total Debt-to-Capitalization Ratio in Use
Take company ABC with short-term debt of $10 million, long-term debt of $30 million, and shareholders' equity of $60 million. The ratio is ($10 million + $30 million) divided by ($10 million + $30 million + $60 million), which equals 0.4 or 40%. This means 40% of its capital structure is debt.
Now look at company XYZ: short-term debt $5 million, long-term debt $20 million, shareholders' equity $15 million. The ratio is ($5 million + $20 million) divided by ($5 million + $20 million + $15 million), equaling 0.625 or 62.5%. Even with less total debt than ABC, debt makes up a bigger part of XYZ's structure, making interest payments tougher in a downturn.
The acceptable debt level depends on the industry. Capital-intensive sectors like utilities, pipelines, and telecom often have high leverage, but their cash flows are more predictable than in sectors with inconsistent earnings.
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