Debt to Capital Ratio

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The debt to capital ratio is a ratio that indicates how leveraged a company is by dividing its interest-bearing debt with its total capital. Most companies are financed by the combination of debt and equity, which is equal to total capital. So, by comparing debt with total capital, we can see the proportion of how much debt in the total capital is being used to fund the company’s operation.

The debt to capital ratio is one of the leverage ratios used by investors and creditors to judge the financial risk of a company. A company that uses too much debt will be in more danger should any financial crisis trigger bankruptcy. In that event, if the company is majorly financed by debts, the company might have trouble paying off its remaining debt. Investors will also be less likely to get a portion of any liquidated assets from the company.

There is no exact number at which the debt to capital ratio is considered acceptable. The common rule is that the higher the ratio, the more leveraged a company is. Therefore, it carries more risk. This ratio is often expressed as a percentage. You may need to multiply the result of the equation to 100%.

Debt to Capital Ratio Formula

Debt\:to\: Capital = \dfrac{Total\: Debt}{Total\: Debt + \text{Shareholder's Equity}}

To calculate the debt to capital ratio, we need to determine the interest-bearing debt of the company. Keep in mind that we don’t calculate total debt in the formula. Instead, we are only looking at debts with interest that need to be paid regularly such as bank loans.

This method may give us a better perspective since not all debts are equally burdening, especially if some are non-interest bearing debts like accounts payable. These are debts owed to vendors or suppliers.

The second variable we need is shareholder’s equity. This is the portion of capital or assets that are financed by shareholders instead of creditors in exchange for stocks. You can also think of equity as a company’s remaining capital if all of the company’s debts are paid off. Interest-bearing debt plus shareholder’s equity equal total capital.

You may notice that total capital is rather similar to total assets, or total liabilities plus shareholder’s equity. The only difference between the two is that total capital doesn’t include any non interest-bearing debt. Alternately, total assets include all debts, whether they incur interest or not.

Interest-bearing debts can be either short-term or long-term debts. All long-term debts usually have a determined interest rate beside the principal amount. This happens since long-term debts carry more risks to creditors compared to short-term debts, so interests provide a little bit of security.

On the other hand, most short-term debts don’t incur interest. The small portion of interest-bearing short-term debts includes bonds payable and notes payable—both of which are variations to accounts payable—that is due within a year.

Debt to Capital Ratio Example

An analyst tries to compare multiple firms for a client that wishes to invest. From all the firms considered, one of which has short-term liabilities that include $50,000 worth of accounts payable, $15,000 worth of notes payable, and $25,000 worth of bonds payable. In addition, the total amount of long-term liabilities are summed up to be $250,000.

For equity, the total value of it is calculated to be $600,000. What is the debt to capital ratio for this particular company?

Let’s break it down to identify the meaning and value of the different variables in this problem.

  • Accounts Payable = 50,000
  • Notes Payable = 15,000
  • Bonds Payable = 25,000
  • Long-term Debts = 250,000
  • Shareholders’ Equity = 600,000

Remember that accounts payable isn’t included in this equation since it doesn’t usually incur interest. In this case, the interest-bearing debt portion that we calculate will be: 15,000 + 25,000 + 250,000 = 290,000.

Now let’s use our formula and apply the values to calculate the debt to capital ratio:

Debt\:to\: Capital = \dfrac{290{,}000}{290{,}000 + 600{,}000} = 32.58\%

In this case, the debt to capital would be 0.3258 or 32.58%.

From this result, we can see that the company is still in a relatively good position with the majority of its capital being financed by equity. This company will be in a safer position rather than another company with a higher debt to capital ratio if any financial trouble were to arise. With that said, debt to capital ratio only measures the risk of a company and doesn’t take profitability into account. To recommend this company, the analyst needs to consider using other kinds of instruments as well.

Debt to Capital Ratio Analysis

Using debt to capital ratio, investors and analysts can have a better view of how companies manage their capital structure. Comparing the debt to capital of different companies will help them decide which company has the perfect balance between risk and potential gain based on their preference. Creditors can also use this ratio to gauge the credit risk of a company to make sure that the company can meet the payment of both principal and interest portion of credits.

The debt to capital ratio is often preferred by analysts compared to other leverage ratios. For instance, another leverage ratio called Debt to Asset ratio or simply Debt Ratio takes total debt into account, which includes non-interest bearing debts. These debts are often the least of corporations’ concern of all debts since they don’t carry as much sense of urgency compared to interest-bearing debts.

As mentioned before, there is no perfect figure for debt to capital ratio. Companies from a certain industry may have a higher ratio than other companies from different industries. This doesn’t necessarily mean that high ratio companies are in a bad condition or riskier than those with a lower ratio. 

For example, companies with stable cash flows, such as pipeline companies, usually have a greater debt to capital ratio than companies with less stable cash flows like technology companies. The reason being pipeline companies have a relatively more stable income since they provide basic needs for people, unlike technology companies that often have volatile income depending on the market.

Debt to Capital Ratio Conclusion

  • The debt to capital ratio measures the proportion of interest-bearing debt within the total capital of a company to gauge how much leverage it uses.
  • The formula for debt to capital requires two variables: Interest-bearing Debt and Shareholders’ Equity.
  • Debt to capital ratio equation uses interest-bearing debts instead of total debt since not all debts carry the same weight.
  • There’s no perfect figure for debt to capital value and different industries have different average values for the ratio.

Debt to Capital Ratio Calculator

You can use the debt to capital calculator below to quickly measure the proportion of interest-bearing debt within the total capital of a company to gauge how much leverage it uses by entering the required numbers.