What is Debt to Capital Ratio?
The Debt to Capital Ratio measures a company’s credit risk by quantifying the proportion of debt relative to the entire capital structure, i.e. the sum of total debt and total shareholders’ equity.
How to Calculate Debt to Capital Ratio?
The debt to capital ratio, often used interchangeably with the term “capitalization ratio”, compares the total debt balance outstanding on the balance sheet of a company to the value of its total shareholders’ equity.
Corporations can raise capital via two methods – debt financing and equity financing – which represent the funding sources that support day-to-day working capital spending and capital expenditures, i.e. the purchases of fixed assets (PP&E).
- Debt Financing → Borrowing Capital from Lenders in Exchange for Periodic Interest Payments and Returning the Original Principal by Maturity
- Equity Financing → Issuance of Shares to Investors in Exchange for Shares in the Company’s Equity, i.e. Partial Ownership Stakes
Therefore, the debt to capital ratio represents the proportion of a company’s capital structure consisting of debt securities.
- Revolving Credit Line (“Revolver”)
- Commercial Paper (CP)
- Term Loans, i.e. Senior Bank Debt
- Corporate Bonds
- Mezzanine Financing Securities
On the other hand, the equity component comprises the capital contributed by the owners, the capital raised in the capital markets via an initial public offering (IPO) or secondary offering, and retained earnings:
- Paid-In Capital
- Retained Earnings
- Issuance of Common Equity
What is a Good Debt to Capital Ratio?
The debt to capital ratio is a method to gauge a company’s current capital structure, specifically in the context of evaluating its credit and default risk.
Generally, a debt to capital ratio higher than that of comparable industry peers signals that the underlying company might be at a greater risk of being incapable of meeting its required debt obligations.
With that said, a lower debt to capital ratio tends to be perceived more favorably, since there is less solvency risk.
There is no single target debt to capital ratio that constitutes a “good” ratio, per se, as it varies substantially across different industries. As such, the interpretation of the ratio and comparisons to other companies must only be done with an in-depth understanding of the factors that pertain to the specific industry in question and among peer companies that share similar fundamental characteristics (e.g. business model, customers, risks).
How to Optimize Capitalization Ratio?
Most notably, the payments associated with raising capital in the form of debt – e.g. periodic interest expense and principal amortization – are contractual obligations. Thus, missing a scheduled payment could lead to a company becoming insolvent and filing for bankruptcy protection.
Debt capital offers companies numerous benefits, namely the interest tax shield (i.e. tax savings stemming from the tax-deductible feature of interest expense) and avoidance of dilution in the existing equity structure, yet an over-reliance on debt financing can easily cause a company to run into problems.
The most common catalyst for financial distress is an unsustainable capital structure, wherein the company’s free cash flows (FCFs) cannot sufficiently handle the current debt burden, which frequently coincides with unexpected developments such as poor financial performance, new entrants in the market, and industry headwinds.
While debt financing is deemed by most to be a “cheaper” source of capital relative to equity financing (at least in the initial stages of a company’s lifecycle), the potential downside is far riskier, e.g. defaulting on debt obligations, entering financial distress, filing for bankruptcy protection in Court (reorganization or liquidation).
With that said, the optimal capital structure must strike the right balance between both so that the benefits of debt financing are realized without putting an unmanageable debt burden on the company’s balance sheet and deteriorating its credit profile.
Debt to Capital Ratio Formula
The formula to calculate the debt to capital ratio is as follows.
- Total Debt: The “Total Debt” input is the sum of all debt and interest-bearing securities sitting on a company’s balance sheet.
- Total Capitalization: The “Total Capitalization” input is the sum of the company’s total debt and total shareholders’ equity, i.e. the funding sources available to the company.
Note that if the market value of equity is used instead of the book value of equity (BVE) – which tends to be more commonly used for valuation purposes, as opposed to for credit analysis (e.g. estimating WACC in a DCF model) – the debt balance must also be the market value of debt. However, barring unusual circumstances, the market value rarely deviates much from the book value of debt, so it is acceptable to use the values recorded on the balance sheet in most cases.
Long Term Debt to Capital Formula
If the objective of credit analysis is specifically intended to isolate the solvency risk of a company – i.e. evaluate the long-term sustainability of the borrower – the calculation can be done without the inclusion of short-term debt obligations with maturities coming due in less than twelve months.
In contrast to the prior formula, the method in which the total debt balance is used assesses not only the borrower’s solvency risk but also the liquidity risk, i.e. long-term and short-term credit analysis.
- Short-Term Debt: Maturity <12 Months
- Long-Term Debt: Maturity >12 Months
Debt to Capital Ratio Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. Capitalization Assumptions
Suppose we’re tasked with calculating the debt to capital ratio for a company in 2022A with the following capitalization.
- Total Assets = $200 million
- Total Debt = $120 million
- Total Equity = $80 million
Of the $120 million in debt, $20 million is short-term, with the remaining $80 million being long-term obligations.
- Revolver = $10 million
- Commercial Paper = $10 million
- Short-Term Debt = $10 million + $10 million = $20 million
- Term Loan B = $80 million
- Total Debt = $100 million
2. Long Term Debt to Capital Ratio Calculation Example
In our company’s capital structure, the only long-term debt consists of a term loan B, so we’ll divide the outstanding balance of the loan by the sum of the total debt and total equity accounts.
- Capitalization = $100 million + $100 million = $200 million
- Long-Term Debt to Capital Ratio = $80 million ÷ $200 million = 0.6x
3. Total Debt to Capital Ratio Calculation Example
In the next part of our exercise, we’ll calculate the total debt to capital ratio, which is inclusive of our company’s short-term and long-term debt obligations.
The short-term debt securities – the revolver and commercial paper – amount to $20 million in borrowings, while the total term loan balance is $80 million.
- Total Debt = $20 million + $80 million = $100 million
The total debt outstanding is $100 million, which we’ll divide by the total capitalization of $200 million to arrive at a total debt to capital ratio of 0.5x, i.e. 50% of the company’s assets are funded by debt capital.