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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 interest-bearing debt, both short- and long-term liabilities and dividing it by the total capital. Total capital is all interest-bearing 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 how much of the capital employed is debt 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 being 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:

       
  Debt-to-Capital Ratio = Interest-bearing Debt  
  Interest-bearing Debt + Equity  
       

Interest-bearing debt includes bank loans, notes payable, bonds payable, etc. Non-interest bearing debt includes accrued expenses, trade payable, etc.

As an example, assume a firm has $100 million in liabilities comprised of:

  • Notes payable $5 million
  • Bonds payable $20 million
  • Accounts payable $10 million
  • Accrued expenses $6 million
  • Deferred income $3 million
  • Long-term liabilities $55 million
  • Other long-term liabilities $1 million

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

As for equity, the company has $20 million worth of preferred stock and $3 million of minority interest listed on the books. The company has 10 million shares of common stock outstanding, which is currently trading at $20 per share. Total equity is $20 million + $3 million + ($20 x 10 million shares) = $223 million. Using these numbers, the calculation for the company's debt-to-capital ratio is:

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

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 referenced company is a safer choice since its financial leverage is approximately half that of the compared company's.

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