Calculating Debt-to-Capital Ratio
Debt-to-capital ratio is the proportion of a company's total capital that is debt.
The ratio is a useful measure of how much a company relies on debt (rather than equity) to finance its operations—and hence the level of risk to its stockholders. It's also a test of creditworthiness, a measure of borrowing capacity, and an indication of whether a company can meet its liabilities (such as payments on scheduled loans or capital leases).
In general, the greater the ratio, the higher the risk to stockholders and lenders—with provisos. For example, a growing company may need to take on more debt to finance its expansion. In some sectors, like manufacturing—particularly in a development phase—or utilities, capital requirement is necessarily high, and likewise the ratio will be high.
Nevertheless, companies with a higher level of debt will need a stable cash flow and strong earning power.
There are many variations of this ratio, including those which divide long-term debt into separate parts. Many analysts see this as unnecessarily complex, preferring a straightforward formula that
divides total liabilities by total capital (liabilities plus stockholders' equity):
Suppose a company's total liabilities amount to $4.5m, and stockholder equity is $7m. Total capital is therefore $11.5m. The debt-to-capital ratio is therefore:
The formula can also be expressed as total debt divided by total funds: the result will be the same.
- Stockholders' equity includes common stock, preferred stock, minority interest, and net debt.
- The definition of "debt" varies, but it should include capital leases.
- Opinions vary about an acceptable debt-to-capital ratio—some say 60% or less, others 40%.
- If a company goes bankrupt, debt holders are paid first—so stockholders are most at risk from a high debt-to-capital ratio. But the risk may be acceptable if return on assets is greater than interest payments on debts.
- Debt-to-capital is not the same thing as debt-to-capitalization (debt measured against total market capitalization, which reflects the movement of stock prices).
Investopedia.com (search for debt-to-capital ratio): www.investopedia.com