Long term debt ratio

By:

Arti

Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000... read more.

Reviewed by:

James Knight

James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.

Updated:  Jun 24, 2024

Ad disclosure

Invezz is an independent platform with the goal of helping users achieve financial freedom. In order to fund our work, we partner with advertisers who may pay to be displayed in certain positions on certain pages, or may compensate us for referring users to their services. While our reviews and assessments of each product are independent and unbiased, the order in which brands are presented and the placement of offers may be impacted and some of the links on this page may be affiliate links from which we earn a commission. The order in which products and services appear on Invezz does not represent an endorsement from us, and please be aware that there may be other platforms available to you than the products and services that appear on our website. Read more about how we make money >

4 min read

3 key takeaways:

• The long-term debt ratio measures the proportion of a company’s capital structure that is financed by long-term debt.
• It helps assess a company’s financial leverage and ability to meet long-term obligations.
• A higher ratio indicates greater reliance on debt, which can increase financial risk but also leverage potential returns.

What is the long-term debt ratio?

The long-term debt ratio is a financial metric that indicates the proportion of a company’s total capital structure that is financed through long-term debt. This ratio provides insights into the company’s financial leverage and its reliance on long-term borrowing to finance operations and growth. It is calculated by dividing long-term debt by the sum of long-term debt and shareholders’ equity.

How to calculate the long-term debt ratio

The formula for calculating the long-term debt ratio is as follows:

[ \text{Long-term debt ratio} = \frac{\text{Long-term debt}}{\text{Long-term debt} + \text{Shareholders’ equity}} ]

For example, if a company has $1 million in long-term debt and $3 million in shareholders’ equity, the long-term debt ratio would be:

[ \text{Long-term debt ratio} = \frac{1,000,000}{1,000,000 + 3,000,000} = \frac{1,000,000}{4,000,000} = 0.25 \text{ or } 25\% ]

Importance of the long-term debt ratio

The long-term debt ratio is crucial for several reasons:

• Assessing leverage: It provides a clear picture of the company’s leverage, showing how much of its financing comes from long-term debt versus equity.
• Financial health: A lower ratio suggests a stronger equity position, while a higher ratio indicates greater reliance on debt, which can increase financial risk.
• Creditworthiness: Lenders and investors use this ratio to evaluate the company’s ability to meet its long-term obligations and overall financial stability.

Implications of the long-term debt ratio

The long-term debt ratio has significant implications for a company’s financial strategy and risk profile:

• Risk assessment: A high long-term debt ratio can signal higher financial risk, as the company must service its debt obligations regardless of its financial performance. This can lead to cash flow pressures, especially during economic downturns.
• Cost of capital: Companies with higher debt ratios may face higher borrowing costs due to the increased risk perceived by lenders. Conversely, a lower debt ratio can result in more favorable borrowing terms.
• Investment decisions: A balanced approach to debt and equity financing can optimize a company’s cost of capital and support sustainable growth. Excessive reliance on debt can lead to overleveraging, while insufficient debt may limit growth potential.

Factors influencing the long-term debt ratio

Several factors can influence a company’s long-term debt ratio:

• Industry norms: Different industries have varying levels of acceptable debt ratios based on their capital intensity and business models.
• Growth stage: Companies in growth phases may have higher debt ratios as they invest heavily in expansion, while mature companies may have lower ratios due to stable cash flows.
• Interest rates: Prevailing interest rates affect the cost of borrowing. Lower interest rates can encourage companies to take on more debt, while higher rates may deter borrowing.
• Financial strategy: Management’s approach to financing, risk tolerance, and long-term goals play a crucial role in determining the debt ratio.

Related topics:

• Debt-to-equity ratio
• Financial leverage
• Capital structure analysis
• Long-term financing strategies
• Risk management in corporate finance

Understanding the long-term debt ratio is essential for evaluating a company’s financial health, assessing its risk profile, and making informed investment decisions. It provides valuable insights into how a company balances debt and equity to finance its operations and growth.