It is simply the total amount of a company’s debt divided by its total capital.
Debt pertains to all of a business’s short-term and long-term debts. Capital pertains to all of the business’s capital which includes common stock, preferred stock, and retained earnings.
What Is the Use of Debt-To-Capital Ratio?
The debt-to-capital ratio can indicate whether or not a company will be able to pay back the interest on those loans, and if it will have enough money left over for other investments such as research and development or acquisitions.
Company managers and investors might also consider using the debt-to-capital ratio to compare businesses within an industry.
Formula to Calculate Debt-To-Capital Ratio
The formula for calculating the debt-to-capital ratio looks like this:
While a debt-to-capital ratio can be calculated for pretty much any company, here’s an example of what the calculation looks like when it’s been used in practice.
Company ABC has $5 million in short-term obligation and $10 million in long-term obligation and has capital or equity amounting to $25 million.
The debt-to-capital ratio would be calculated this way:
Debt/Capital = Debt/ (Debt + Total Equity)
= 5 + 10 / (15 + 25)
= 15 / 40
= 0.375 or 37.5%
This means that 37.5% of Company ABC’s operations are funded using both short-term and long-term debts.
When Is a Debt-To-Capital Ratio Considered Favorable?
Generally, the higher the debt-to-capital ratio is, the riskier it is for a business. If the ratio is too high, it may indicate that the company’s earnings are not enough to cover the cost of its debts and other liabilities.
However, if a business has a debt-to-capital ratio below 50%, it may be able to make larger investments in its future without having to use as much equity financing.
Some businesses also choose to finance almost all their operations using loans or other forms of debt because it can reduce their tax bill. These companies should have a lower debt-to-capital ratio than those that do not take advantage of these tax benefits.
A company’s debt-to-capital ratio is considered favorable if it’s lower than the industry average and the interest expenses on their debts don’t eat up too much of their profits.
Company managers can compare a firm’s debt-to-capital ratio to those of other companies within an industry, as well as against averages for all businesses.
Debt-To-Capital vs Debt Ratio
The debt ratio illustrates a firm’s total liabilities as a percentage of its total assets, while the debt-to-capital ratio illustrates a firm’s total debt as a percentage of its capital.
This means that both will give you information about how risky or financially stable a company is, but each one can also tell you something different about that business’ operations and funding.
Limitations of Debt-To-Capital Ratio
The debt-to-capital ratio can help give you an idea of how risky or secure a business is, but it only analyzes two financial concepts.
Businesses with equal debt-to-capital ratios may have very different debt profiles and this could make it difficult to make comparisons between them.
For example, one business may have a lot of bank loans secured by physical assets while the other uses credit cards to finance its ongoing operations.
Additionally, the debt-to-capital ratio does not take cash flow into account. A company could have a 0% debt-to-capital ratio because they are using equity financing to pay off their debts but still be in dire financial straits if they are struggling to generate income through sales and other sources.
The debt-to-capital ratio is a useful financial ratio that measures the amount of debt a company uses to finance its everyday operations.
It can also be used as a benchmark tool for determining whether a firm has too much or too little outstanding debt.
Because this ratio is based on information from a company’s balance sheet, it has its own limitations.
This is not a very ideal liquidity ratio to be used by businesses without strong balance sheets, such as startups or those prone to seasonal cash flow fluctuations.
Even so, the debt-to-capital ratio is worth analyzing because it can help show you how well your business manages its finances and what areas it needs to improve in order to stay competitive over time.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.