The Finance Owl

Banks – Loans – Mortgages – Money

Historical Background on the Debt to Capital Ratio

This ratio explains the proportion of Debt and Capital that a company is using to finance its operations. The company Debt to Capital ratio is frequently compared to industry benchmark Debt to Capital ratios, and is widely quoted in the financial media.

What is the Debt to Capital Ratio?

The definition for the Debt to Capital ratio is calculated for a quoted company as:

Debt to Capital Ratio = Total Liabilities / Total Assets

This therefore differs to the Debt to Equity ratio because it compares the debt to the total financing of the company, rather than just the equity element.

Other Debt to Capital Calculations

An alternative calculation used by some investors only looks at long-term liabilities (since it could be argued that short-term liabilities have little to do with the financing of a company). This definition is:

Debt to Capital Ratio = Long-Term Liabilities / Total Assets

What Does the Debt to Capital Ratio Mean to Industry and the Investor?

Industry and investors will possibly look at the relative size of the Debt to Capital ratio. The reason for this is that a high Debt to Capital ratio can possibly indicate that an organization has a relatively high commitment to pay fixed interest charges. The frequency of these fixed interest charges will be dependent on the terms of the long-term finance. It is worth noting that it is always critical to take professional investment advice before making any financial investment decisions.

The Debt-to-Capital ratio also gives the investor indicators of the organization’s ability to borrow money.

Why Does Industry View the Debt-to-Capital Ratio as Important?

Investors find it useful to compare the Debt to Capital ratio of a company compared to the Debt to Capital ratio of comparative companies and the industry. This helps give a comparative gauge of how the organization is perceived from a risk perspective.
The Debt to Capital ratio is only an indicator and simply raises more questions, however it is still a crucial financial ratio. Historical Debt to Capital ratio analysis also provides useful information, because this historical analysis (when compared with the industry analysis) can help provide some insights into the historical risk level of the business.

Is a Historically High Debt-to-Capital Ratio Good or Bad for the Investor?

Simplistically the greater the proportion of debt (and therefore the higher the Debt-to-Capital ratio) the higher the perceived risk of the organisation. However history is only one indicator of future performance. Again it is also important to take professional investment advice before making investment decisions.

What Are the Key Problems With Debt-to-Capital Ratio Analysis of a Company or an industry?

Three possible key problems with the Debt-to-Capital ratio are:

  1. Investors & industry sometimes wrongly assume that a low ratio makes the best investment.
  2. Investors & industry often do not carry out deep fact based comparative analysis (investors often compares ratios which have used different definitions).
  3. Investors & industry must be crystal clear on which definition they are using (for example if the second calculation above is used, then what defines a long-term liability? i.e. compare “apples with apples”).

What Are the Secondary Problems with Debt to Capital Ratio Analysis of a Company or an Industry?

Possible secondary problems with the Debt to Capital ratio include the following:

  • Debt to Capital ratios use historical data. Historic data is not always a sound basis for future returns.
  • The Debt to Capital can vary due to short-term influences.
  • Investors will find that Debt to Capital ratios tend to be industry specific and it is important therefore for the investor to carry out industry analysis.

What is Considered a Good Debt to Capital Ratio?

It is difficult to assess if any ratio (including the debt-to-Capital calculation) is good or bad without assessing the industry, comparable businesses and also the strategy of the organisation. However one view could be debt-to-Capital ratios which are less than 1 and greater than 1.