What Is the Debt-To-Capital Ratio?

What Is the Debt-To-Capital Ratio?

Let me explain the debt-to-capital ratio directly: it's a straightforward measurement of a company's financial leverage. You calculate it by taking the company's interest-bearing debt, including both short- and long-term liabilities, and dividing it by the total capital. Total capital means all that interest-bearing debt plus shareholders' equity, which can include common stock, preferred stock, and minority interest.

Key Takeaways

This ratio serves as a clear measurement of a company's financial leverage, determined by dividing interest-bearing debt by total capital. Remember, all else equal, a higher debt-to-capital ratio means the company is riskier. While most companies use a mix of debt and equity to finance operations, just looking at total debt might not give you the full picture you need.

The Formula for Debt-To-Capital Ratio

Here's the formula you need: Debt-To-Capital Ratio = Debt / (Debt + Shareholders' Equity). You calculate it by dividing a company’s total debt by its total capital, where total capital is total debt plus total shareholders’ equity.

What Does Debt-To-Capital Ratio Tell You?

The debt-to-capital ratio gives you, as an analyst or investor, a solid idea of a company's financial structure and if it's a good investment. All else being equal, a higher ratio makes the company riskier because it shows more funding from debt than equity, leading to higher liabilities for repayment and greater risk if the debt isn't paid on time.

That said, a certain amount of debt might cripple one company but hardly impact another. Using total capital provides a more accurate picture of the company's health, as it frames debt as a percentage of capital instead of just a dollar figure.

Example of How to Use Debt-To-Capital Ratio

Take this example: suppose a firm has $100 million in liabilities, broken down as 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, and other long-term liabilities $1 million. Only notes payable, bonds payable, and long-term liabilities are interest-bearing, totaling $5 million + $20 million + $55 million = $80 million.

For equity, the company has $20 million in preferred stock and $3 million in minority interest. It also has 10 million shares of common stock trading at $20 per share, so total equity is $20 million + $3 million + ($20 x 10 million) = $223 million. The debt-to-capital ratio is $80 million / ($80 million + $223 million) = $80 million / $303 million = 26.4%.

If you're a portfolio manager considering this company and compare it to another with a 40% ratio, all else equal, this one is safer because its leverage is about half.

A Real-Life Example

Look at Caterpillar (NYSE: CAT) as a real case: as of December 2018, it had $36.6 billion in total debt and $14 billion in shareholders’ equity. Its debt-to-capital ratio is $36.6 billion / ($36.6 billion + $14 billion) = 72%.

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 to show how much of a company’s assets are financed with debt. These can be similar since total assets equal total liabilities plus shareholders’ equity, but the debt-to-capital ratio excludes all liabilities except interest-bearing debt.

Limitations of Using Debt-To-Capital Ratio

Be aware that the debt-to-capital ratio can be influenced by the accounting methods a company uses. Financial statements often rely on historical cost accounting, which might not reflect current market values. Make sure you're using the correct values in your calculation to avoid distorting the ratio.