What It Measures
The percentage of total funding represented by debt.
Why It Is Important
By comparing a company’s 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 company’s 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
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
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
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 company’s return on assets exceeds the rate of interest paid to creditors.