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
Debt-to-capital ratio=reebt + Shareholreers‘ EquIttherereebtTheThe
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.
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.