The debt-to-capital ratio is a vital measurement of a company’s financial leverage. It is calculated by examining a company’s interest-bearing debt, encompassing both short- and long-term liabilities, and dividing it by the total capital. Total capital combines all interest-bearing debt and shareholders’ equity, which may include elements like common stock, preferred stock, and minority interest.
Key Takeaways
- Financial Leverage Indicator: The debt-to-capital ratio measures a company’s financial leverage by dividing its interest-bearing debt by the total capital.
- Risk Assessment: Generally, a higher debt-to-capital ratio indicates a riskier company, as it implies a heavier reliance on debt for funding operations.
- Comprehensive Analysis: While total debt insights are crucial, they might not fully reflect financial health. Hence, the ratio provides a clearer picture by comparing debt to total capital.
The Formula for Debt-To-Capital Ratio
The formula to calculate the debt-to-capital ratio is:
[ \text{Debt-To-Capital Ratio} = \frac{\text{Debt}}{\text{Debt} + \text{Shareholders’ Equity}} ]
The ratio is derived by dividing a company’s total debt by its total capital, which comprises total debt and total shareholders’ equity.
Interpreting the Debt-To-Capital Ratio
The debt-to-capital ratio offers analysts and investors a deeper understanding of a company’s financial structure, helping them gauge investment suitability. Generally, a higher ratio signals greater risk, as it denotes more debt funding than equity. This translates to high repayment obligations and increased risk of loan forfeiture if the company faces repayment issues.
However, the impact of debt considerably varies across different companies. Thus, using total capital for this calculation provides a more accurate picture of the company’s financial health because it contextualizes debt as a part of its overall capital.
Practical Example of the Debt-To-Capital Ratio
Let’s delve into a practical example:
Consider a company with $100 million in liabilities, including:
- 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
Here, only notes payable, bonds payable, and long-term liabilities are interest-bearing, which total $80 million ($5 million + $20 million + $55 million).
For equity, suppose the company has $20 million in preferred stock and $3 million in minority interest. Additionally, it has 10 million common shares outstanding, trading at $20 per share. Thus, total equity amounts to $223 million ($20 million + $3 million + $200 million).
By applying the formula, we get:
- Debt-to-capital ratio: [{80\text{ million} \over 80\text{ million} + 223\text{ million}} = {80\text{ million} \over 303\text{ million}} \approx 26.4%]
If an investor is comparing this company with another that has a debt-to-capital ratio of 40%, the lower ratio company appears safer, assuming all other things are equal.
Practical Application: Caterpillar’s Case Study
Consider Caterpillar (NYSE: CAT) as a real-world example. As of December 2018, Caterpillar had $36.6 billion in total debt and $14 billion in shareholders’ equity. The debt-to-capital ratio is calculated as follows:
[
\text{Debt-to-Capital Ratio} = {36.6\text{ billion} \over 36.6\text{ billion} + 14\text{ billion}} = 73
]
Comparing Debt-To-Capital Ratio with Debt Ratio
While the debt-to-capital ratio measures total debt against total capital, the debt ratio compares total debt to total assets. Though these figures can align closely, it’s key to note the debt-to-capital ratio focuses specifically on interest-bearing debts while excluding other liabilities.
Limitations of Using the Debt-To-Capital Ratio
The ratio might be skewed by the accounting methods a company utilizes. Values reported in financial statements based on historical cost accounting may not accurately reflect current market values. Therefore, verifying accurate and up-to-date values for the ratio calculation is crucial to maintain its integrity.
Related Terms: debt ratio, financial leverage, shareholders’ equity, total debt, capital structure
References
- Caterpillar. “10-K Annual Report 2018”, Page 46.
- Caterpillar. “10-K Annual Report 2018”, Page 24.
