How to Calculate Debt to Capital Ratio

If you’re looking to learn more about common finance ratios in business, debt-to-capital ratio is commonly used by finance professionals. Debt to capital ratio is used to measure the financial leverage of a business by comparing its total capital to its total liabilities. Knowing how to calculate debt to capital ratio can help you understand its debts fuel how much of a businesses. 

1. Calculate the total debt

The first step in calculating debt to capital ratio is adding the total debt of a business. You can add the short-term debt to the long-term debt to get your total debt amount. From this amount, subtract any cash from the business accounts to get the total debt amount. 

2. Calculate the total capital

After calculating the total debt of a business, you can calculate the total capital. To calculate the total capital, subtract the current liabilities from the current assets. Current assets include cash, inventory, and accounts receivable, while current liabilities include taxes, interest, wages, and accounts payable. 

3. Divide the total capital by the total debt

To calculate the debt to capital ratio, the final step is to divide the total capital by the total debt. This amount can show the debt to capital ratio of the business and can show how much of the business operations relies on debt to function. You can use this ratio to make educated financial decisions and to calculate the long-term health of the business..

As an example, assume a business has 75 million in liabilities comprising:

Notes payable $7 million
Bonds payable $13 million
Miscellaneous expenses $10 million
Deferred income $2 million
Long-term liabilities $42 million
Short-term liabilities $1 million

To calculate the total debt of the company, you can add the interest-bearing securities including notes payable, bonds payable, and long-term liabilities.

To calculate equity, assume the business has $25 million in preferred stock and $2 million in minority interest recorded in their books. They have 20 million shares of common stock outstanding, which is currently trading at $10 per share. 

Using the numbers calculated above, the debt to capital ratio is:

Financial Analysis

When potential lenders are looking at issuing a loan, they often look at the debt to capital ratio of a business to see their financial position. This can give investors an idea of the ability of the business to pay off the loan. The nature of the payment structure can impact the debt to capital ratio of a business as businesses that accept payments at the end of the completion of work operate at a negative debt to capital ratio temporarily. 

Risk Analysis

Debt to capital ratio can give lenders and investors an idea of the risk involved with doing business. Having a negative debt to capital ratio can show that your business is a riskier investment than a business with a positive ratio. Any investors looking to lend may require a business to provide their ratios and numbers before they approve a loan.

Issuing shareholder earnings

As debt to capital ratio is an indicator of what a business owes compared to what they earn, someone often factor it into shareholder earnings. Shareholders receive a portion of your profits but we calculate the amount based on net income. Since net income is determined after I paid your debts off, debt to capital ratio provides an accurate picture as to the amount a shareholder can expect to make if they invest in the business.

Accounting methods 

The accounting practices may affect debt a business adopts. Some accounting practices base their financial statements off the historical cost of goods which may not reflect the current market value. This can lead to an undervalued total capital amount which can skew the ratio unfavourably. To mitigate this problem, investors can cross-reference the reported value with market values to get a more accurate ratio.

Accounts receivable 

Depending on when a business collects payment, the debt to capital ratio may not reflect business operations. Businesses that collect full payment prior to completing work may have a ratio that having greater capital before paying off debts. A business that collects payment after they have completed work may have a different ratio outcome. This is because they may need to pay the expenses of the project before collecting payment. To mitigate this problem, investors can use yearly totals in their calculations and account for all work completed, not all projects currently underway. 

Industry

Debt to capital ratios vary between industries making them difficult to compare. What we consider high in one industry may be low in a different industry. Ratios can also vary between companies and depending on how they structure their financing, what we consider operational can change. When looking at debt to capital ratios, it’s important to look at how they change over time and account for any discrepancies. For example, one business may rely heavily on investors for funding, but issue more stock options. A business with limited stock options may spend more of their capital on funding their endeavours. 

Information

As investors, it's difficult to access the information needed to calculate debt to capital ratio. As they often protect debt information, the debt to capital ratio of businesses can be difficult to calculate. When comparing multiple businesses, it can be time-consuming to locate the required information of all the debts and capital amount. Investors can request this information while expressing intent to invest, and businesses may be more lenient to share.

Besides debt to capital ratio, there are two other ratios that can show the financial leverage of a business including:

Debt to equity ratio

A common way for businesses to fund growth and new initiatives is to sell stocks to the public which is known by equity financing. The debt-to-equity ratio of a business shows how much financing comes from banks or stockholders. This ratio is an important factor when establishing the long-term health of a business. It shows funds fully owned by the business finance how much of a business’s debt. It reflects the ability of a business to finance all outstanding debt in the event they need to liquidate. 

Debt to equity ratio can be calculated by dividing total liabilities by total equity. It is a baseline ratio meaning its value is determined in relation to one. If the debt-to-equity ratio is equal to one, a business has equally financed its assets with debt and equity. If the ratio is higher than one, a business has financed its assets with more debt than equity. If the ratio is lower than one, a business has financed its assets with more equity than debt. 

Interest coverage ratio

Interest coverage ratio looks at the earnings of a business in relation to their interest payments. This ratio is helpful in understanding if a business can afford the interest that accrues on its assets. The ratio calculates how long and for which we can make interest payments with the currently available funds of the business. Analyzing interest coverage ratios over time can give investors an accurate picture of the health of a business and can be useful in calculating the risk of an investment. 

To calculate interest coverage ratio, you can take the earnings before interest and taxes and divide it by the interest expense of a business. If their ratio is below the value of 1.5, their ability to pay off their interest payments may be at risk. The ability of a company to make its interest payments is a large factor of its solvency and investors may be interested in knowing the interest coverage ratio of a business before they invest.