Every business operation requires money and careful financial management is an important part of running it. Employing monetary strategies like debt financing and investment to increase financial leverage will lead to more available capital; however, this will also increase your debt. So, how do you know whether leverage is working for you or not?
This is where you need to take the help of financial leverage ratios. Leverage ratios are used to determine how well a business is using financial leverage to finance its core operations and meet its long-term debt obligations. It can also help you understand whether a company will be able to handle its interest payments or principal payment on the debt.
Most Common Types of Leverage Ratios
Some of the most commonly found leverage ratios are:
- Debt-to-Assets Ratio
- Debt-to-Equity Ratio
- Debt-to-Capital Ratio
- Asset-to-Equity Ratio
Let us take a look at the long-term debt to capitalisation ratio in detail.
What is the Long-term Debt to Capitalisation Ratio?
The two types of liabilities a firm can owe is short-term and long-term. Short-term debt is the money owed in debts and loans that is due within 1 year, while long-term debt is not due for 12 months or more than 12 months from the balance sheet date.
The debt is recorded on the balance sheet along with its interest rate and date of maturity as a non-current liability. Long-term debt ratio gives a clear picture of financial leverage of a company and compares the amount of long-term debt to the value of total assets of a company. The long-term debt of a company tells you how much leverage a company has and how solvent the company is.
Total capitalisation is the sum of long-term debt and equities. The capitalisation ratio is the total debt against the total capitalisation and is used as financial leverage to gauge a company’s equity.
Different Types of Long-term Debts
There are different types of long-term debts.
- Bank debt is a loan issued by a bank or any other financial organisation. These are not tradable or transferable.
- Mortgages are loans taken on real estate property, such as land and buildings.
- Bonds are publicly tradable securities issued by a corporation with a maturity of longer than a year.
- Debentures are loans that are not backed by a specific asset.
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Long-term Debt to Capitalisation Ratio – Why is it Important for Both a Company and its Investors?
The long-term debt to capital ratio is a vital calculation for any business – small, medium or big. It is also equally important for the investors as well.
➣ Allows investors to identify the amount of control utilised by a company
The long-term debt to capitalisation ratio allows investors to gauge the total risk of investing in a particular business. The ratio shows how financially stable or unstable a company is by indicating how much has been financed by investor funds or equity.
For investors, a high long-term debt to capitalisation ratio would indicate the financial weakness of the firm you have invested in or are planning to invest in. An increasing debt would most likely increase the risk of the company. As an investor, to analyse the total risk experience of a particular company, you can identify the amount of control utilized by a company and compare it with other similar ones.
➣ Helps to determine the financial risks that the company has taken
So, how do you know, by checking the long-term debt to capitalisation ratio, whether a company has taken a financial risk or not?
A higher long-term debt to capitalisation ratio means that the company has more debts than capital. Owning lesser assets indicates that there is a lesser cash flow that in turn means that the company has lesser ability to finance new operations. In other words, it would need to sell more assets to generate strong revenue and cash flow for a long period in the future to be able to repay the debt.
This is not a good thing for a business as it can lead to a lot of financial problems – getting blacklisted and the worst scenario - bankruptcy. As a business owner, making sure the long-term debt to capitalisation ratio is under control is important. An overwhelming debt would create problems to the company as a whole. A lower long-term debt to capitalisation ratio indicates that the business is not going through any financial crisis.
➣ Increase shareholders' return on equity
A high long-term debt to capitalisation ratio plays an important role in increasing a shareholders' return on equity because interest payments are tax-deductible. However, it also reduces a company's financial flexibility because they have a higher debt capital structure.
If the long-term debt to capitalisation ratio is less than 1 that means the business does not have much financial difficulties and that the debt levels are manageable. However, you should keep in mind that a declining ratio value means that there is a growth in the company’s capital.
➣ Measures the higher risk of insolvency
A business can choose between using debt or equity to finance their business. If the debt is used for financing the firm instead of using equity financing, the risk of insolvency also increases. High risk is a tell-tale sign of the company's failure to repay its debt commitments and the chances of default increases. If you, as a business owner are looking for additional loans or to extend your loan, you will have to keep one thing in mind. Banks and most of the major lending organisations review insolvency or bankruptcy risk before approving loans or extending credits.
➣ Lower a company's total cost of capital
When compared to long-term debt, equity is an expensive source of financing. By using long-term debt, companies can lower the total cost of capital. This can be done by offsetting the interest payments made on existing debt and, in that way, reducing the company’s taxable income. Tax liabilities help to preserve the company’s cash flows and the total value of the company.
On the other hand, when a company finances with equity, it must share profits proportionately with its shareholders.
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How to Calculate Long-term Debt to Total Capitalisation
The total capital is the sum of the long-term debt and its common and preferred stock:
Total capital = long-term debt + common stock + preferred stock
The long-term debt to total capitalisation ratio is calculated using the formula given below:
Long-term debt / long-term debt + stockholder's equity
Let's take a look at an example to understand the calculation.
Company AB1 has a capital structure as follows:
Long-term debt = $1000M
Common stock = $300M
Preferred stock = $100M
The long-term debt to total capitalisation ratio would be 1000 / 1000 + 300 + 100 = 0 .71 (71%). The ratio value of 0.71 indicates that the company’s total available capital is made up of 71% of its long-term debt.
Ultimately, a company’s capital structure lets you know how well the management is utilizing debt and their stockholders’ capital to create value for the business. A lower ratio value may be what you are looking for in a company, as it indicates that the management is doing a great job to keep their debt under control.
However, the calculated ratio also depends upon the industry in which the company is operating. For instance, in industries that operate on higher leverage such as manufacturing, a higher value might not be a cause for concern and it does not necessarily mean that the company is going through financial troubles.
Long-term debts are useful if a company can convert it into strong growth and easily pay the interest. It is important that companies should take into account the long-term debt to capitalisation ratio to make sure their debt is under control.
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