What is the 'Debt-To-Capital Ratio'
The debt-to-capital ratio is a measurement of a company's financial leverage. The debt-to-capital ratio is calculated by taking the company's debt, including both short- and long-term liabilities and dividing it by the total capital. Total capital is all debt plus shareholders' equity, which may include items such as common stock, preferred stock and minority interest.
BREAKING DOWN 'Debt-To-Capital Ratio'
While most companies finance their operations through a mixture of debt and equity, looking at total debt or net debt of a company may not provide the best information. Since a specific amount of debt may be crippling for one company yet barely affect another, analyzing the entire company's financial leverage gives a more accurate picture of the company's health. The debt-to-capital ratio gives analysts and investors a better idea of a company's financial structure and whether or not the company is a suitable investment. All else equal, the higher the debt-to-capital ratio, the riskier the company.
The debt-to-capital ratio may be affected by the accounting conventions a company uses. Often, values on a company's financial statements are based on historic cost accounting and may not reflect the true current market values. Thus, it is very important to be certain the correct values are used in the calculation so the ratio does not become distorted.
Debt-to-Capital Ratio Calculation and Example
The simplified formula for the debt-to-capital ratio is:
A more clear formula for the ratio is:
Debt-to-capital = (short-term liabilities + long-term liabilities) / (short-term liabilities + long-term liabilities + total equity)
As an example, assume a firm has $500 million in total assets. It has $45 million in short-term liabilities and $55 million in long-term liabilities. As for equity, the company has $35 million worth of preferred stock and $5 million of minority interest listed on the books. The company has 15 million shares of common stock outstanding, which is currently trading at $25 per share. Using these numbers, the calculation for the company's debt-to-capital ratio is:
Debt-to-capital = ($45 million + $55 million) / ($45 million + $55 million + $35 million + $5 million + ($25 x 15 million)) = $100 million / $400 million = 25%
Assume this company is being considered as an investment by a portfolio manager. If the portfolio manager looks at another company that had a debt-to-capital ratio of 40%, all else equal, the above company is a safer choice since its financial leverage is half that of the second company's.