What it means
Businesses fund themselves with a mixture of debt and equity, and the balance between the two is called the capital structure. The long-term debt ratio isolates the borrowed portion of that structure, ignoring short-term items such as overdrafts and trade creditors so that the picture is not distorted by normal trading swings.
The ratio matters because debt is a fixed commitment while equity is not. Interest and repayments must be met whether trading is good or bad, so the higher the ratio, the more of the company's future cash flow is already spoken for before anything reaches the owners.
Managers use it when deciding how to fund the next major project. If the ratio is already at 55%, most boards would fund a new facility from retained profit or fresh equity rather than pushing borrowing higher, particularly when earnings are volatile.
There is a competing definition worth knowing about, because some analysts calculate long-term debt divided by total assets instead of by total capital. Both are called the long-term debt ratio in practice, so it is always worth confirming which denominator is in use before comparing two published figures.
Context is everything when judging the result. A utility with predictable regulated income can carry 60% comfortably, while a fashion retailer facing swings in demand might be uncomfortable above 25%, and neither number is right or wrong on its own.
The ratio also moves for reasons that have nothing to do with new borrowing, which is worth remembering before reading too much into a change. Retaining profits, issuing shares, revaluing property or writing off an intangible asset all shift equity and therefore the percentage, so it pays to check which side of the calculation actually moved.
In practice
Real-world examples.
Example
A regional water utility carries a long-term debt ratio of 58% and its investors are relaxed, because tariffs are set years in advance and cash flow is highly predictable. The rating agency focuses on interest cover rather than the headline ratio.
Example
A software business preparing for a funding round shows a ratio of 8%, having grown mostly on equity and customer prepayments. Investors see plenty of unused borrowing capacity, which supports the valuation being discussed.
Example
A haulage operator's ratio jumps from 30% to 52% after financing 40 new vehicles. When fuel costs spike the following year, the fixed repayment schedule leaves no room to absorb the increase and two depots are closed, a decision the board later traces back to funding a fleet renewal entirely with debt instead of splitting it across debt and retained cash.
Think of it
“Long-term debt ratio is like measuring what percentage of your total wealth is committed to multi-year obligations like mortgages.
Formula
Calculation
Long-Term Debt Ratio = Long-Term Debt / (Long-Term Debt + Shareholders Equity)
A packaging company has a ten-year term loan and lease obligations totalling $4,000,000, all repayable beyond twelve months, and shareholders' equity of $6,000,000. Adding these gives total long-term capital of $10,000,000.
Dividing $4,000,000 by $10,000,000 gives 0.40, which is 40%. If the company then repaid $1,000,000 of the loan using retained profit, long-term debt would fall to $3,000,000, equity would rise to $6,000,000 plus the retained amount, and the ratio would drop to roughly 30% on a total capital base of $10,000,000.Case study
Seen in the real world.
Calderway Print Group is an invented company used here for illustrative purposes only. It funded a decade of expansion almost entirely with long-term borrowing, taking its long-term debt to $9 million against equity of $6 million, a long-term debt ratio of 60%.
While print volumes held up, the arrangement worked and the owners kept full ownership of a growing business. In this fictional example a large publishing client then moved to digital delivery, revenue fell by a fifth, and the annual $1.4 million of loan repayments suddenly consumed almost all available cash.
Calderway negotiated a two-year repayment holiday on part of the debt and converted a further $2 million into preference shares held by a specialist investor. The long-term debt ratio fell to 41%, the founders gave up some economic ownership, and the business survived a downturn that its previous capital structure could not have absorbed.
Watch out
Common mistakes.
- Including overdrafts, trade creditors and other short-term balances, which belong in short-term measures rather than this one.
- Comparing a figure calculated on total capital with one calculated on total assets, which produces a misleadingly large difference.
- Judging the ratio without looking at whether earnings actually cover the interest, since affordability matters more than the percentage itself.
Questions
People also ask.
What is a healthy long-term debt ratio?
Many stable trading companies sit between 20% and 40%, but capital intensive sectors with predictable income safely operate well above that.
Does a ratio of zero mean a company is well run?
Not necessarily, because some borrowing at a lower cost than the return on the money can raise shareholder returns, so no debt at all may mean missed opportunity.
How does the ratio change when profits are retained?
Retained profits increase equity, which enlarges the denominator and lowers the ratio even if no debt has actually been repaid.
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