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.
- Measurement of a company's financial leverage, calculated by taking the company's interest-bearing debt and dividing it by total capital.
- All else equal, the higher the debt-to-capital ratio, the riskier the company.
- While most companies finance their operations through a mixture of debt and equity, looking at the total debt of a company may not provide the best information.
The Formula for Debt-To-Capital Ratio
Debt-To-Capital Ratio=Debt + Shareholders′ EquityDebt
The debt-to-capital ratio is calculated by dividing a company’s total debt by its total capital, which is total debt plus total shareholders’ equity.
What Does Debt-To-Capital Ratio Tell You?
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. This is because a higher ratio, the more the company is funded by debt than equity, which means a higher liability to repay the debt and a greater risk of forfeiture on the loan if the debt cannot be paid timely.
However, while a specific amount of debt may be crippling for one company, the same amount could barely affect another. Thus, using total capital gives a more accurate picture of the company's health because it frames debt as a percentage of capital rather than as a dollar amount.
Example of How to Use Debt-To-Capital Ratio
As an example, assume a firm has $100 million in liabilities comprised of the following:
- 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.
As a real-life example, consider Caterpillar (NYSE: CAT), which has $36.6 billion in total debt as of December 2018. Its shareholders’ equity for the same quarter was $14 billion. Thus, its debt-to-capital ratio is 73%, or $36.6 billion / ($36.6 billion + $14 billion).
The Difference Between Debt-To-Capital Ratio and Debt Ratio
Unlike the debt-to-capital ratio, the debt ratio divides total debt by total assets. The debt ratio is a measure of how much of a company’s assets are financed with debt. The two numbers can be very similar, as total assets are equal to total liabilities plus total shareholder’ equity. However, for the debt-to-capital ratio, it excludes all other liabilities besides interest-bearing debt.
Limitations of Using Debt-To-Capital Ratio
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 historical 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.