Debt-to-Capital Ratio: Definition, Formula, Example & Calculation
The world of investments is a tricky place to navigate. Many investors can be on the wrong end of a bad investment and lose a significant amount of money.
In order to try and reduce the risks associated with investment, many people will carry out a large amount of research. This is before putting any money forward.
When an investor is deciding which company would be best to invest in, there are a number of different metrics and ratios that can be used. This is in order to gauge their financial health and performance.
One of the more useful ratios is what’s known as the debt-to-capital ratio. But what exactly is this ratio? We’ll take a closer look at the definition, show you the formula and an example, as well as break down a calculation.
Here’s What We’ll Cover:
What Is the Debt-to-Capital Ratio?
The debt-to-capital ratio is a liquidity ratio. It measures a company’s total liabilities against its total capital to gauge its overall financial health.
It refers to how much of the operations of a business are funded using debt in comparison to how much is funded by pure capital.
As well as gauging the financial leath, it can also be an effective way to figure out a company’s risk profile. This is before you put money into it as an investor, or business owners can use the ratio to get a better idea of the overall health of their company.
The debt-to-capital ratio can be figured out by taking the company’s interest-bearing debt, both short and long term liabilities, and dividing it by its total capital.
The total capital is all interest-bearing debt plus any shareholder’s equity. This may include things such as common stock, minority interest or preferred stock.
What Is the Formula for Debt-To-Capital Ratio?
There is a simple and straightforward formula that you can use to figure out this financial ratio:
DTCR=DebtDebt + Shareholders' Equity
You can see here that it’s a simple calculation. All that’s needed is for you to divide the company’s total debt by its total capital, which is its total debt plus any shareholders’ equity.
As we mentioned earlier, it’s important to note that debt includes all short and long term liabilities. This as well as the shareholders’ equity should be a sum of all of the company’s equity, from common and preferred stock to minority interest.
Once you have figured out the calculation, you will see that the higher the ratio, the more risky an investment the business would be.
This is because the higher the ratio is, the more the business is funded by debt rather than by equity. In turn, this means that they have a higher liability to repay the debt and therefore a greater risk of forfeiture if the debt cannot be repaid.
What Is an Example of the Debt-to-Capital Ratio?
Let’s take a look at a straightforward example of using the debt-to-capital ratio.
Let’s say that your company lists $40,000 in short-term liabilities and $70,000 in long-term liabilities on your balance sheet.
You’ve also issued $20,000 in preferred stock, $5,000 in minority interest, and have around 8,0000 outstanding shares which are trading at $1 per share.
With all of this information, you can complete the debt-to-capital ratio formula:
DTCR=(40,000+70,000)(40,000+70,000) + (20,000+5,000) + (8,000+1) =0.512
So essentially, 51.2% of your company’s operations are funded with debt instead of capital. This would make your business a relatively risky investment as it is financing growth activities with debt.
How Do You Use the Debt-to-Capital Ratio?
This ratio is essentially a measure of risk. If a company is financing its day-to-day business operations through debt, then there is a high level of risk. This is because the principal plus interest must be paid back to whoever the debt was leveraged from.
As a result of this, any company with a high ratio is an inherently riskier venture. A downturn in the business’s sales could lead to potential solvency problems.
It’s important to note though that a higher ratio isn’t always negative. If the loans are used properly and managed well then it could lead to a large return for any investor or shareholders. But again, this would be riskier.
What Are the Limitations of the Debt-to-Capital Ratio?
As with any risk measuring ratio, the debt-to-capital ratio has its limitations. The financial metric is always going to be affected by the company’s accounting practices.
This is because any entry on their financial statements are more likely to be based on historical cost accounting. This is rather than based on their current market values.
If a company uses these entries to calculate their ratio, they may not accurately reflect the business’s actual financial leverage.
That’s why it’s absolutely vital that the correct values are used whenever a debt-to-capital ratio analysis is being performed. This is so that the ratio doesn’t become distorted.
The debt-to-capital ratio is a simple concept when considering investment in a business, but it’s also an important one.
Investing money into a business that has a high ratio could end up being problematic. This is especially true if they see a downturn in sales or are affected by stock market volatility.
As with any financial ratio, the debt-to-capital ratio should be used alongside other important financial ratios in order to try and get the best idea possible of a company.
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