Contents
What’s it: The debt-to-capital ratio is a leverage ratio calculated by dividing the total debt by the company’s total capital. Total capital equals total debt plus total equity.
A higher ratio indicates high leverage. A company depends more on debt than equity in its capital. It’s considered riskier because it has to pay it off, even when not generating revenue.
High debt also reduces a company’s financial flexibility and increases the default risk. Then, failure to pay off debt can encourage creditors to file for bankruptcy against the company.
Why is the debt-to-capital ratio important?
Companies rely on capital to finance their business. It can come from equity capital and debt capital. Equity capital represents ownership. Meanwhile, debt capital represents an obligation in which the company has to pay interest and principal.
Debt capital can come from several sources, including commercial paper, bank loans, or bonds. Take bonds as an example. Companies must spend money regularly to pay interest and pay off the principal when due.
Companies must pay debts, even when they have no income. For this reason, high debt reduces their financial flexibility and increases their financial risk.
And, the debt-to-capital ratio tells us how much a company depends on debt. So, while the ratio may not say much about its ability to pay off debt (because it doesn’t compare it to cash inflow metrics such as cash from operations), it’s an important measure of how financially healthy the company is.
When the ratio is high, companies rely on more debt than equity. As a result, the company has a high leverage level, which implies high credit risk. Thus, along with other solvency ratios, lenders usually examine this ratio when making credit decisions.
Creditors use this ratio to evaluate a company’s default risk. When the risk is high, they will be more reluctant to extend new loans. Or, they will charge for higher interest to compensate for the higher risk.
Therefore, when the debt-to-capital ratio is high, the company may find it difficult to obtain new debt. And it could limit the company’s ability to finance future expansion.
How to calculate the debt-to-capital ratio?
Calculating the debt-to-capital ratio is easy because it only requires arithmetic operations. We just need to divide the total debt by the total capital.
Total debt refers to interest-bearing debt, both long-term and short-term. Meanwhile, total capital equals total debt plus total equity. We can find these figures on the balance sheet.
- Debt-to-capital ratio = Total debt / Total capital
- Debt-to-capital ratio = Total debt / (Total debt + Total equity)
Take a simple example. A company reports short-term debt of $500,000 in the current liabilities. It also presents the current portion of long-term debt of $300,000. In non-current liabilities, it reports long-term debt of $2 million. Meanwhile, its total equity is $5.6 million.
From the data, we can calculate the company’s total debt is $2.8 million = $500,000 + $300,000 + $2 million. Meanwhile, its total capital is $8.4 million = $2.8 million + $5.6 million. After getting both, we then calculate the debt-to-capital ratio, which is 0.33 = $2.8 million / $8.4 million.
How to interpret the debt-to-capital ratio?
A higher ratio is less desirable because it indicates a higher financial risk. This is because companies rely more on debt than equity to grow their business. Consequently, they must spend more money in the future to pay interest and principal.
Conversely, a lower ratio is preferred because the company is less dependent on debt. That results in smaller interest and principal payments.
But, indeed, how high or low the ratio can be can vary between industries. It depends on the nature of the business. In some industries, a high ratio is tolerable because it is accompanied by good cash-generating capabilities. While in others, it is a bad sign.
Is a high debt-to-capital ratio always bad?
In some cases, creditors may still tolerate a high debt-to-capital ratio because the company can generate sufficient and regular cash. Thus, it can pay its contractual obligations on time. That is why companies in some sectors, such as utilities, tend to have higher ratios than companies in other sectors.
However, if a high ratio is not accompanied by adequate cash inflows, companies are more likely to default. Long story short, because the company has to pay interest periodically, the company needs sufficient and stable cash inflows. Otherwise, its ability to pay debts deteriorates.
Furthermore, although increasing debt reduces financial flexibility, some companies still take on more debt. They seek to find the optimal capital structure at which the cost of capital is minimized. They formulate how much debt they have to take, considering their equity.
When a company can make more money with new debt, it can increase its market value if it generates higher returns than the additional cost of capital incurred.
