What is the Debt to Capital Ratio?
Definition: The debt to capital ratio is a liquidity ratio that calculates a company’s use of financial leverage by comparing its total obligations to total capital. In other words, this metric measures the proportion of debt a company uses to finance its operations as compared with its capital.
This ratio is really a measure of risk and allows us to calculate how well a company can handle a down turn in sales because it highlights the relationship between debt and equity financing. Financing operations through loans carries some level of risk because the principal and interest must be paid to the lender. Thus, companies with higher ratios are considered more risky because they must maintain the same level of sales in order to meet their debt servicing obligations. A down turn in sales could spell solvency issues for the company.
On the other hand, debt loan financing also presents an opportunity for abnormal returns to shareholders. When the loans are used in an efficient manner i.e. if the company earns more on loans than the cost of debt – the shareholders’ returns increase.
Investors use the debt-to-capital metric to gauge the risk of a company based on its financial structure. A high ratio indicates that the company is extensive using debt to finance its operations; whereas, a low metric means the company raises its funds through current revenues or shareholders. Likewise, creditors use this measurement to assess whether the company is suitable for a loan or is too leveraged to afford one.
Now let’s look at how to the calculate debt to capital ratio.
The debt to capital ratio formula is calculated by dividing the total debt of a company by the sum of the shareholder’s equity and total debt.
As you can see, this equation is pretty simple. The total debt figure includes all of the company short-term and long-term liabilities. The shareholder’s equity figure includes all equity of the company: common stock, preferred stock, and minority interest.
Let’s try to understand this with the help of an example.
Let’s assume a portfolio manager is considering investing in one of two companies. He has two options, Company A or Company B. Both the companies are operating in the manufacturing sector and are in their expansion phase.
The Company A has $300M in total assets. It has $30M in short-term liabilities and $45M in long-term liabilities. The company also has $25M worth of preferred stock issued and an additional $2M of minority interest. Company A has a total of 10M outstanding shares that are currently being traded at $15 per share. Company A’s debt to capital ratio equation can be calculated like this:
Company B, on the other hand, reports the following figures on its balance sheet:
Total liabilities: $50M
1M $50 shares outstanding: $50M
Thus, Company B’s ratio would be calculated like this:
The financial risk associated with Company B is quite high, as it is aggressively financing its growth with debt. Company A, on the other hand, has more overall liabilities, but their shareholder’s have more skin in the game.
After careful consideration by the portfolio manager, Company A appears to be a safer choice for investment, as its financial leverage is almost half of the other company.
Debt to capital is an important measure to identify how much a company is dependent on debt to finance its day-to-day activities and to estimate the risk level to a company’s shareholders. It also measures the creditworthiness of a firm to meet its liabilities in the form of interest expenses and other payments.
Typically the higher the ratio, the greater the risk to lenders and shareholders, but this is not always the case. As with any financial metric, this can’t be analyzed in a vacuum. A high ratio does not always mean a bad thing. Look at utility companies for instance. They often carry high levels of debt because their operations are capital intensive. This translates into a higher debt-to-capital ratio, but it doesn’t mean they will be insolvent soon. Utility companies have an extremely steady base of customers and as such their revenues are consistent. This means they are able to meet their obligations without worrying about downturns in revenues.
Contrast this with new, expanding companies. These companies might not have established customer bases, but they still need to finance their day to day operations. They may have steady sales at the moment, but this is not a guarantee like with the utility companies. Eventually, the new company sales could level off or simply decrease leaving fewer funds to service its debt. A high debt to capital ratio for this company would indicate risk.
If the debt-to-capital ratio is greater than 1, the company has more debt than capital. This company is extremely risky. If any more liabilities are acquired without an increase in earning, the company might go bankrupt.
On the other hand, if the ratio is less than 1, the debt levels are manageable and the firm is considered less risky to invest or loan to given other factors are taken into consideration.