Debt/Capital Ratio

Whether called debt/capital ratio, debt-to-capital ratio, or simply debt ratio, this is a fundamental tool in analyzing how a company is funded. It is also known as the gearing ratio.

What It Measures
The percentage of total funding represented by debt.

Why It Is Important
By comparing a companys long-term liabilities to its total capital, the debt/capital ratio provides a review of the extent to which a company relies on external debt financing for its funding and is a measure of the risk to its stockholders. The debt/capital ratio is also a measure of a companys borrowing capacity, and of its ability to pay scheduled financial payments on term debts and capital leases. Bond-rating agencies and analysts use it routinely to assess creditworthiness. The greater the debt, the higher the risk. However, it can be misleading to assume that the lowest ratio is automatically the best ratio. A company may assume large amounts of debt in order to expand the business. Utilities, for instance, have high capital requirements, so their debt/capital ratios will be high as a matter of course. So are those of manufacturing companies, especially those developing a new technology or new product. At the same time, the higher the level of debt, the more important it is for a company to have positive earnings and steady cash flow.

How It Works in Practice

Although there are variations on exactly what goes into this ratio, the most common method is to divide total long-term debt by total assets (total long-term debt plus stockholders funds), or: Debt/capital ratio = Total liabilities Total assets For example, if the balance sheet of a corporate annual report lists total liabilities of $9,800,000 and total stockholders equity of $12,800,000, the debt/capital ratio is (calculating in thousands): 9,800 (9,800 + 12,800) = 9,800 22,600 = 0.434 = 43.4% Some formulas distinguish different portions of long-term debt. However, that complicates calculations and many experts regard it as unnecessary. It is also common to express the formula as total debt divided by total funds, which produces the same outcome.

Tricks of the Trade

If a company has minority interests in subsidiaries that are consolidated in the balance sheet, they must be added to stockholders equity. Debt calculations should include capital leases. One rule of thumb holds that a debt/capital ratio of 60% or less is acceptable, but another holds that 40% is the most desirable. A high debt/capital ratio means less security for stockholders, because debt holders are paid first in bankruptcies. It still can be tolerable, however, if a companys return on assets exceeds the rate of interest paid to creditors.

Debt/Capital Ratio

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Do not confuse the debt/capital ratio with debt/capitalization, which compares debt with total market capitalization and fluctuates as the companys stock price changes.

See Also
Calculations Capitalization Ratios Debt/Equity Ratio

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