Long-Term Debt to Capitalization Ratio

Definition

The long-term debt to capitalization ratio measures the proportion of a company’s long-term debt relative to its total capital. It is a leverage metric that indicates how much of a firm’s financing comes from long-term borrowings versus equity and preferred stock.

Calculation

Long-term debt to capitalization = Long-term debt / (Long-term debt + Preferred stock + Common equity)

The ratio is expressed as a decimal or percentage. A higher value means a greater share of capital is supplied by long-term debt.

Interpretation

• Low ratio: The company relies more on equity and preferred stock, which generally implies lower financial leverage and lower risk of insolvency related to fixed debt obligations.
• High ratio: The company is highly leveraged, increasing the risk that it may struggle to meet debt payments during revenue shortfalls. High leverage can magnify returns in good times but raises bankruptcy risk in downturns.

How it affects cost of capital

Long-term debt often carries a lower pre-tax cost than equity because interest payments are contractual and can be tax-deductible. As a result, adding debt can reduce a company’s weighted average cost of capital (WACC) up to a point. However:
* Debt reduces WACC only if the added financial risk does not materially raise the required returns on debt and equity.
* Excessive debt increases the probability of distress, which raises both borrowing costs and the equity risk premium.

Financing risk and coverage

A dominant share of long-term debt increases financing risk. Analysts commonly compare debt obligations to operating cash flow measures (for example, debt service coverage or EBITDA) to assess whether earnings are sufficient to cover debt payments. Persistent shortfalls—where debt payments frequently exceed operating income—signal rising insolvency risk.

When debt can be appropriate

Debt financing may be advantageous when:
* The company expects stable, predictable cash flows sufficient to meet interest and principal.
* Debt costs are lower than the cost of raising additional equity.
* Management prefers not to dilute existing shareholders.

Key takeaways

• The ratio shows the share of financing provided by long-term debt versus equity and preferred stock.
• Higher ratios indicate greater financial leverage and higher insolvency risk.
• Moderate use of debt can lower a company’s cost of capital, but excessive debt increases financing risk and borrowing costs.
• Assess the ratio alongside coverage metrics (e.g., EBITDA vs. debt service) to judge whether debt levels are sustainable.