The total debt-to-capitalization ratio measures the proportion of a company’s capital structure that is funded by debt. It is a leverage metric: a higher ratio means a larger share of the firm’s capital comes from borrowings (short‑term and long‑term debt) rather than owners’ equity. Because debt requires fixed interest and principal payments, a high ratio implies greater financial risk—especially if cash flows are volatile.
Formula
Total debt-to-capitalization = (Short-term debt + Long-term debt) / (Short-term debt + Long-term debt + Shareholders’ equity)
Where:
– Short-term debt (SD) includes bank lines, commercial paper and the current portion of long-term debt reported as a liability on the balance sheet.
– Long-term debt (LTD) includes bonds, notes and other noncurrent borrowings.
– Shareholders’ equity (SE) is total shareholders’ equity as reported (common stock, retained earnings, additional paid-in capital, less treasury stock).
Two equivalent forms:
– Debt / (Debt + Equity)
– Debt / Total capitalization
Worked examples
Example 1 — Company ABC
– Short-term debt = $10 million
– Long-term debt = $30 million
– Shareholders’ equity = $60 million
Total debt = $10m + $30m = $40m
Total capitalization = $40m + $60m = $100m
Total debt-to-capitalization = $40m / $100m = 0.40 = 40%
Interpretation: 40% of ABC’s capital structure is debt.
Example 2 — Company XYZ
– Short-term debt = $5 million
– Long-term debt = $20 million
– Shareholders’ equity = $15 million
Total debt = $25m; Total capitalization = $25m + $15m = $40m
Total debt-to-capitalization = $25m / $40m = 0.625 = 62.5%
Interpretation: Although XYZ has less absolute debt ($25m vs $40m for ABC), debt makes up a much larger portion of its capital structure, increasing XYZ’s vulnerability to cash-flow shortfalls.
What the ratio tells you (and what it doesn’t)
– Tells you: relative financial leverage (how much capital is supplied by creditors vs owners); higher values suggest greater fixed obligations and potentially higher bankruptcy risk.
– Doesn’t tell you: whether the company can service the debt (use interest coverage or cash flow measures for that), the cost of debt, or the market value of equity. The ratio uses balance-sheet/book values by default, which can differ materially from market values.
Industry context and acceptable ranges
– Acceptable leverage varies by industry. Capital-intensive industries (utilities, pipelines, telecom) commonly operate with higher debt ratios but often have stable cash flows. Tech, consumer discretionary or cyclicals usually have lower acceptable debt levels.
– There is no universal cutoff, but as a rule of thumb: below ~30–40% is generally conservative; 40–60% is moderate; above ~60% is higher leverage and warrants closer scrutiny. Always compare to industry peers and historical company levels.
Practical steps for analysts and managers — how to calculate and use the ratio
1. Pull the most recent balance sheet (company filings, e.g., 10‑Q/10‑K).
2. Identify components:
• Short‑term debt = current portion of long‑term debt + short‑term borrowings (exclude trade payables).
• Long‑term debt = noncurrent borrowings and bonds.
• Shareholders’ equity = total equity on the balance sheet.
3. Compute total debt and total capitalization, then compute the ratio.
4. Adjust if needed (see adjustments below).
5. Benchmark:
• Compare the ratio to historical company levels (trend analysis).
• Compare to direct competitors and industry averages.
6. Combine with other ratios:
• Interest coverage ratio (EBIT/Interest expense) to assess debt-servicing ability.
• Debt-to-equity and debt-to-assets for complementary views.
• Free cash flow metrics for coverage and repayment capacity.
7. Flag red lights: rising ratio over time, ratio materially above peers, low interest coverage, and short-term maturities concentrated in the near future.
Common and recommended adjustments (practical considerations)
– Operating leases / lease liabilities: Under current accounting (ASC 842 / IFRS 16), many leases already appear on the balance sheet. If older reports omit operating leases, add the present value of lease obligations to debt.
– Capital leases and finance leases: Treat like debt.
– Pension deficits and other long-term liabilities: Consider adding material operating obligations if they represent long-term fixed commitments.
– Preferred stock: Some analysts include redeemable or cumulative preferred shares in “debt-like” capital; others include them in equity. Be consistent and disclose your approach.
– Convertibles: If conversion is likely and would dilute equity, adjust accordingly (treat as debt until conversion if debt-like).
– Net debt vs. gross debt: Sometimes analysts compute net debt (debt minus cash and equivalents) and use net debt/(net debt + equity) to reflect liquid resources available to pay debt.
– Market vs. book equity: For market-based analysis (e.g., takeover or market-risk view) use market capitalization instead of book equity; this yields Debt / (Debt + Market Cap). Be clear which method you use.
Limitations and caveats
– Book-value bias: Equity on the balance sheet may be outdated and not reflect current market value of equity or retained earnings adjustments.
– Off‑balance-sheet exposure: Some obligations may be underdisclosed or contingent.
– Seasonality and timing: Debt balances can change materially within a reporting period—use trailing averages or multiple date checks for accuracy.
– Cross-country accounting differences: Presentation of debt and leases can vary across jurisdictions.
How investors and managers should use this ratio
– Investors: use it to screen for leverage risk, compare capital structure across peers, and combine with coverage metrics and cash-flow analysis before making investment decisions.
– Creditors: use it to assess debt cushion and probability of default; pay attention to covenant thresholds tied to capitalization ratios.
– Management: monitor the ratio to manage optimal capital structure, cost of capital, and financial flexibility. Use scenario analysis and stress testing to ensure coverage under adverse conditions.
Red flags and follow-up questions when the ratio is high
– Is interest coverage declining? (Check EBIT/Interest)
– Are debt maturities concentrated in the near term?
– Is the company dependent on variable-rate debt in a rising-rate environment?
– Is operating cash flow sufficient and stable?
– Are there looming off‑balance‑sheet obligations or contingent liabilities?
Key takeaways
– The total debt-to-capitalization ratio = debt / (debt + equity) and measures leverage.
– Higher ratios imply greater creditor financing and higher financial risk, but “acceptable” levels vary by industry.
– Always combine with cash-flow and coverage metrics, adjust for off‑balance-sheet items, and benchmark to peers.
– Use either book- or market-based equity consistently and disclose assumptions.
Further reading / source
– Investopedia — Total Debt-to-Capitalization Ratio
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.