Understanding the Debt-to-Capital Ratio: Definition & Calculations

What Is the Debt-To-Capital Ratio?

The the debt-to-capital ratio is a metric used to assess financial leverage by dividing total debt by total capital. Total capital consists of both interest-bearing debt and shareholders' equity, such as common stock. This ratio comes in handy when comparing the financial health and investment risk of different companies. All else being equal, the higher the debt-to-capital ratio, the riskier the company. Bear in mind that, since most companies finance their operations through a mixture of debt and equity, looking at the total debt of a company may not provide the best or most complete information about a company's financial well-being.

Calculating the Debt-To-Capital Ratio: Formula Explained

$\text{Debt-To-Capital Ratio} = \frac{Debt}{Debt \text{ }+\text{ } Shareholders'\ Equity}$Debt-To-Capital Ratio=Debt + Shareholders′ EquityDebt​

To calculate the debt-to-capital ratio, divide the company's total debt by its total capital—this includes total debt and shareholders' equity.

Understanding Insights from the Debt-To-Capital Ratio

The debt-to-capital ratio helps analysts and investors assess a company's financial structure and investment suitability. A higher ratio indicates more debt relative to equity, signaling greater risk because of increased repayment obligations.

A debt amount that cripples one company might hardly affect another, so using total capital frames debt as a percentage, offering a clearer picture of a company's health.

Practical Example of Using the Debt-To-Capital Ratio

As an example, assume a firm has $100 million in liabilities comprised of the following:

• Notes payable $5 million
• Bonds 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 total $5 million + $20 million + $55 million = $80 million.

The company's equity includes $20 million in preferred stock and $3 million in minority interest. With 10 million common shares at $20 each, total equity amounts to $223 million. Using these numbers, the calculation for the company's debt-to-capital ratio is:

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

If a portfolio manager compares this company to another with a 40% debt-to-capital ratio, this company, with a lower ratio, appears safer due to less financial leverage.

As a real-life example, consider Caterpillar (NYSE: CAT), which has $36.6 billion in total debt as of December 2018. Its shareholders’ equity for the same quarter was $14 billion. Thus, its debt-to-capital ratio is 72%, or $36.6 billion / ($36.6 billion + $14 billion).

Comparing Debt-To-Capital Ratio vs. Debt Ratio

The debt ratio divides total debt by total assets, showing how much of a company’s assets are financed with debt. While it can be similar because total assets equal liabilities plus equity, the debt-to-capital ratio only includes interest-bearing debt.

Recognizing the Limitations of the Debt-To-Capital Ratio

Accounting methods can influence the debt-to-capital ratio, as financial statements often use historical costs that don't reflect current market values. It’s crucial to use accurate figures in calculations to avoid distortion.

The Bottom Line

The debt-to-capital ratio is a key measure of a company's financial leverage. It's calculated by dividing total debt by total capital. The higher ratio, the greater the amount of debt a company has and the greater the risk for investors should the company be unable to pay what it owes. Burdens of debt differ from company to company. So a dollar figure for debt alone isn't a useful metric. When framed in relation to total capital, investors and analysts can get a more accurate picture of corporate financial health.