Wednesday, September 30

Debt to Capital Ratio

What is the Debt to Capital Ratio?

Definition: The debt to capital ratio is a liquidity ratio that computes a firm’s use of financial leverage by assessing its entire obligations to complete funding. To put it differently, this metric measures the percentage of debt that a business uses to fund its operations compared to its own capital.

This ratio is truly a measure of danger and permits us to compute how well a firm may manage a downturn into earnings since it highlights the association medially equity and debt funding. Funding operations through loans take some amount of risk since the principal and attention has to be paid for your lending company. Therefore, companies with greater rates are considered risky since they need to maintain an equal degree of earnings to be able to fulfill their debt servicing responsibilities. A downward turn in earnings could spell solvency problems for the business.

On the other hand, debt consolidation lending presents a chance for unexpected returns to investors. If the loans have been employed in an efficient fashion i.e. when the organization earns more about loans compared to the price of debt the banks return boost.

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 extensively 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 calculate debt to capital ratio.

Formula

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.

Debt to Capital Ratio Formula

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 asset, preferred asset, and minority interest.

Let’s try to understand this with the help of an example.

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.

Company A has $300M in total stocks. It has $30M in short-term liabilities and $45M in long-term liabilities. The company also has $25M worth of preferred asset issued and an additional $2M of minority interest. Company A has a total of 10M outstanding stocks that are currently being traded at $15 per share. Company A’s debt to capital ratio equation is calculated like this:

Debt to Capital Ratio Example

Company B, on the other hand, reports the following figures on its balance sheet:

Total liabilities: $50M
1M $50 stocks 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 its shareholders 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.

Analysis

Debt to capital is an important measure to identify how many 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 examined in a vacuum cleaner. A high ratio doesn’t always signify a poor thing. Consider utility companies for example. They frequently carry elevated levels of debt since the operations are more capital intensive. This translates into a greater debt-to-capital ratio, however 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 a boost 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.