Debt-To-Capital Ratio Definition

Debt-To-Capital Ratio Definition

What is the debt to capital ratio?

The debt-to-capital ratio is a measure of a company’s financial leverage. The debt-to-capital ratio is calculated by taking the company’s interest-bearing debt, both short-term and long-term liabilities, and dividing it by total capital. Total capital corresponds to all interest-bearing debt plus equity, which may include items such as common shares, preferred shares and minority interests.

The debt-to-capital ratio formula

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How to calculate the debt / capital ratio

The debt-to-capital ratio is calculated by dividing a company’s total debt by its total capital, which is total debt plus total equity.

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Debt-to-capital ratio

What does the debt / capital ratio tell you?

The debt-to-capital ratio gives analysts and investors a better idea of ​​the financial structure of a business and whether or not the business is worth investing. All else being equal, the higher the debt-to-capital ratio, the more risky the business. However, while a specific amount of debt can be crippling for one business, but barely affect another. Thus, the use of total capital gives a more precise picture of the health of the company.

While most companies finance their operations with a mix of debt and equity, examining a company’s total debt or net debt may not provide the best information. Interest bearing debt includes bank loans, bills payable, bonds payable, etc. Non-interest bearing debt includes accrued liabilities, trade payables, etc.

Key points to remember

  • A measure of a company’s financial leverage, calculated by taking the company’s interest-bearing debt and dividing it by total capital.
  • All other things being equal, the higher the debt-to-capital ratio, the more risky the business.
  • While most companies finance their operations with a mix of debt and equity, examining a company’s total debt may not provide the best information.

Example of using the debt / capital ratio

For example, suppose a business has a liability of $ 100 million consisting of the following:

  • $ 5 million notes payable
  • Obligations payable $ 20 million
  • Accounts payable $ 10 million
  • Accrued liabilities $ 6 million
  • Deferred revenue $ 3 million
  • Long-term liabilities $ 55 million
  • Other long-term liabilities $ 1 million

Of these, only notes payable, obligations payable and long-term liabilities are interest-bearing securities, of which the total amount of $ 5 million + $ 20 million + $ 55 million = $ 80 million dollars.

In terms of equity, the company owns $ 20 million of preferred shares and $ 3 million of minority interests on the books. The company has 10 million common shares outstanding, which are currently trading at $ 20 per share. Total equity is $ 20 million + $ 3 million + ($ 20 x 10 million shares) = $ 223 million. Using these figures, the calculation of the company’s debt / capital ratio is as follows:

  • Debt to capital = $ 80 million / ($ 80 million + $ 223) = $ 80 million / $ 303 million = 26.4%

Suppose this company is considered an investment by a portfolio manager. If the portfolio manager looks at another company that had a debt / capital ratio of 40%, all other things being equal, the referenced company is a safer choice since its financial leverage is about half that of the compared company.

As a concrete example, consider Caterpillar (NYSE: CAT), which has total debt of $ 36.6 billion for its last fiscal quarter as of February 27, 2019. Its equity for the same quarter was $ 14 billion . Thus, its debt / capital ratio is 73%, or $ 36.6 billion / ($ 36.6 billion + $ 14 billion).

The difference between the debt to capital ratio and the debt ratio

Unlike the debt-to-capital ratio, the debt ratio divides total debt by total assets. The debt ratio is a measure of the proportion of assets in a debt-financed enterprise. The two figures can be very similar, since total assets equals total liabilities plus total equity. However, for the debt / capital ratio, it excludes all other liabilities with the exception of interest-bearing debt.

Limits on the use of the debt / capital ratio

The debt / capital ratio can be affected by the accounting policies used by a company. Often the values ​​shown in a company’s financial statements are based on historical cost accounting and may not reflect true market values ​​today. Thus, it is very important to ensure that the correct values ​​are used in the calculation, so that the ratio does not distort.

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