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.
For stock investors that favor companies with good fundamentals, a "strong" balance sheet is an important consideration for investing in a company's stock. The strength of a company's balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy; asset performance; and capital structure. In this article, we'll look at evaluating balance sheet strength based on the composition of a company's capital structure.
A company's capitalization (not to be confused with market capitalization) describes the composition of a company's permanent or long-term capital, which consists of a combination of debt and equity. A healthy proportion of equity capital, as opposed to debt capital, in a company's capital structure is an indication of financial fitness.
Clarifying Capital Structure Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization, i.e. a permanent type of funding to support a company's growth and related assets.
A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities – it is the latter that forms the debt component of a company's capitalization – but that's not the end of the debt story.
Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-term debt. This definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a company's capitalization should consist of the following: short-term borrowings (notes payable); the current portion of long-term debt; long-term debt; two-thirds (rule of thumb) of the principal amount of operating leases; and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors.
It's worth noting here that both international and U.S. financial accounting standards boards are proposing rule changes that would treat operating leases and pension "projected-benefits" as balance sheet liabilities. The new proposed rules certainly alert investors to the true nature of these off-balance sheet obligations that have all the earmarks of debt.
Is There an Optimal Debt-Equity Relationship?
In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expense and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments.
A company considered too highly-leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly-competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.
Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels.
Capital Ratios and Indicators
In general, analysts use three ratios to assess the financial strength of a company's capitalization structure. The first two, the so-called debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position.
The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.
The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt + total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt.
Additional Evaluative Debt-Equity Considerations
Companies in an aggressive acquisition mode can rack up a large amount of purchased goodwill in their balance sheets. Investors need to be alert to the impact of intangibles on the equity component of a company's capitalization. A material amount of intangible assets need to be considered carefully for its potential negative effect as a deduction (or impairment) of equity, which, as a consequence, will adversely affect the capitalization ratio.
Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter how problematic a company's financial condition may be, the holders of these obligations cannot demand payment as long as the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded debt to total debt disclosed in the debt note in the notes to financial statements, the better. Funded debt gives a company more wiggle room.
Lastly, credit ratings are formal risk evaluations by credit-rating agencies – Moody's, Standard & Poor's, Duff & Phelps and Fitch – of a company's ability to repay principal and interest on debt obligations, principally bonds and commercial paper. Here again, this information should appear in the footnotes. Obviously, investors should be glad to see high-quality rankings on the debt of companies they are considering as investment opportunities – and be wary of the reverse.
The Bottom Line
A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of investment quality.