Definition of debt / capital ratio

What is the debt to capital ratio?

The debt ratio is a measure of a company’s financial leverage. The debt-to-capital ratio is calculated by taking the interest-bearing debt of the business, both short-term and long-term liabilities, and dividing it by total capital. Total capital is all interest-bearing debt plus equity, which can include items such as common stock, preferred stock, and minority interests.

The debt-to-capital ratio formula



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How to calculate the debt to capital ratio

The debt-to-capital ratio is calculated by dividing a company’s total debt by its total capital, which is total debt plus total equity.

What does the debt-to-capital ratio tell you?

The debt-to-equity 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 other things being equal, the higher the debt ratio, the riskier the business. This is because the higher the ratio, the more the company is financed by debt than by equity, which means a higher obligation to repay the debt and a greater risk of loan forfeiture if the debt cannot. be paid on time.

However, while a specific amount of debt can be crippling for one business, the same amount could hardly affect another. Thus, using total capital gives a more accurate picture of the health of the business because it defines debt as a percentage of capital rather than dollar amount.

Key points to remember

  • A measure of a company’s financial leverage, calculated by taking the company’s interest-bearing debt and dividing it by total equity.
  • All other things being equal, the higher the debt-to-capital ratio, the riskier the business.
  • While most businesses finance their operations through a mixture of debt and equity, examining a company’s total debt may not provide the best information.

Example of use of debt / capital ratio

As an example, suppose a business has a liability of $ 100 million that consists of the following:

  • Notes payable $ 5 million
  • Obligations 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 totals $ 5 million + $ 20 million + $ 55 million = $ 80 million. .

On the equity side, the company has $ 20 million in preferred stock and $ 3 million in minority interests on the books. The company has 10 million common shares outstanding, which are currently trading at $ 20 per share. Total equity is $ 20 million + $ 3 million + (20 million shares x 10 million shares) = $ 223 million. Using these numbers, the calculation of the company’s debt ratio is:

  • Debt on capital = $ 80 million / ($ 80 million + $ 223) = $ 80 million / $ 303 million = 26.4%

Suppose this company is considered an investment by a portfolio manager. If the portfolio manager looks at another company that had a debt ratio of 40%, all other things being equal, the referenced company is a safer choice since its leverage is about half that of the compared company.

As a concrete example, consider Caterpillar (NYSE: CAT), which had $ 36.6 billion in total debt as of December 2018.Its equity for the same quarter was $ 14 billion.Thus, its debt ratio is 73%, or $ 36.6 billion / ($ 36.6 billion + $ 14 billion).

The difference between the debt ratio and the debt ratio

Unlike the debt ratio, the debt ratio divides total debt by total assets. The debt ratio is a measure of the share of a company’s assets that is funded by debt. The two numbers can be very similar because Total Assets equals Total Liabilities plus Total Equity. However, for the debt-to-capital ratio, it excludes all other liabilities other than interest-bearing debt.

Limits on the use of the debt-to-capital ratio

The debt ratio can be affected by the accounting conventions used by a business. Often, the values ​​shown in a company’s financial statements are based on historical cost accounting and may not reflect true current market values. Thus, it is very important to make sure that the correct values ​​are used in the calculation, so that the report is not skewed.

Sallie R. Loera