What is the Debt to Capital Ratio?
Definition: Debt to capital ratio is a financial ratio used in determining the financial leverage of a company through a comparison of its debt and total capital. This measure determines the percentage of debt the company is using to finance its operations relative to its total capital. Usually, companies getting funding through a combination of equity and debt which accounts for total capital. Therefore a comparison of total capita with debt can help in determining the amount of debt the company is using to finance its operations as part of total capital.
The ratio which is a risk metric enables the calculation of the ability of the company to manage a sales downturn since it shows the correlation between equity financing and debt. Normally financing company operations through debt is associated with risk since you have to pay back the principal to the lender plus interest. Therefore a company that has a higher debt to capital ratio is risky since it has to maintain sales at a particular level so that it can meet its debt servicing commitments. A decline in sales could push the company into insolvency.
However, debt financing can sometimes present a potential for extraordinary returns to equity holders. If the company uses the credit facility efficiently by earning more on the loans relative to the cost of the loans then there is a likelihood that shareholder returns could grow. Usually, there is no acceptable debt-to-capital ratio but if it is higher than it means the company is more leveraged and thus it is risky.
Debt to Capital Ratio Formula
To determine debt to the capital ratio formula you need to calculate total debt that bears interest. These are debts that have to be repaid with interest regularly such as loans.
Total debt will include all the company’s long-term and short-term debts. Long term debts usually have interest attached to the principal amount and they usually have a term of over one year.
Short-term loans do not accrue interest and they include notes payable and bonds payable that are due in less than a year. Shareholder’s equity comprises the company’s total equity-like minority interest, preferred stock, and common stock.
Debt to Capital Ratio Example Analysis
Analysts and investors use the ratio to get an understanding of how the company is managing its capital structure. They can then compare debt to capital ratio of various entities to assist in deciding on the company with a good risk to gain balance. On the other hand, creditors will employ the ratio to evaluate the company’s credit risk to ascertain if the company will be in a position to meet its debt repayment obligations. The leverage ratio is also a measure of a company’s creditworthiness to meet its debt commitments in terms of principal, interest as well as other payments.
Usually, if the ratio is high, then the risk is higher for shareholders and lenders although that is not the case always. But like most financial ratios you can’t analyze debt to capital ratio without taking into consideration other factors. It is important to remember that a high debt-to-capital ratio is not necessarily something bad because a company can have high debt levels because of its capital intensive operations. This will translate to a high ratio but that doesn’t imply that the company will run into insolvency. For instance, utility firms that have a steady customer base generate revenues consistently and therefore it means they can meet debt commitments without concerns of downturns in sales.
Summary
It is important to note that you cannot have a perfect value for the ratio as different companies will have a different value depending on the industry they operate in. Therefore it doesn’t mean that a company with a higher ratio is risker or bad relative to one with a low ratio.