What is the Debt to Capital ratio?
While analyzing a company’s Capital Structure, Solvency Ratios are most widely used.
Debt to Capital ratio is one such Solvency ratio.
This ratio is most often used by Investors and Lenders to evaluate if the company is overburdened with Debt.
Debt to Capital ratio Meaning
As part of the Capital Structure, a Company may have Debt Capital and/or Equity Capital.
Debt Capital refers to the money borrowed by the Company from the lenders to run the business.
Equity Capital refers to the money given by the Equity Shareholders, the owners of the company.
Now, Debt to Capital ratio basically shows how much of the company’s Capital is funded by Debt Capital.
It helps in understanding if the company has taken significant Debt such that it is overburdened to meet Interest Expense.
Let us look at the formula and a few examples to understand the ratio better.
Debt to Capital ratio Formula
The formula for the debt to Capital ratio is quite simple.
We take Total Debt in the numerator and Total Capital in the denominator.
Below are the important considerations while calculating the numerator and denominator.
Total Debt
- Total Debt refers to the money borrowed by the company from the lenders as part of its business.
- It Includes both long term and short term debt.
Total Capital
- Capital refers to the overall resource deployed by the company as part of its operations.
- In the simplest form, the money provided by the shareholder to the company is referred to as Equity.
- Equity Capital will have several components like Common Stock, Share Capital, Retained Earnings, Minority interest, etc. All the components are reported by the company on its Balance Sheet.
- Hence, Capital Includes both Debt and Equity.
- It represents the overall funds available to the company to run the operations.
Hence,
Total Capital = Total Debt + Total Equity
Having understood the formula, let us quickly look at a few examples to apply the same.
Debt to Capital ratio Example
As part of the example, let us consider two Companies- Alpha Inc. and Beta Inc.
Below given is the Balance Sheet extract of both the companies.
All the values are in $millions.
To calculate the Debt to Capital ratio, we need
- Total Debt
- Total Equity
- Total Capital
Both the values can be obtained from the Balance Sheet given above.
Let us calculate one by one.
Total Debt = Short term loan + Long term loan
- Alpha Inc. = $30 + $150 = $ 180
- Beta Inc. = $20 + $100 = $ 120
Total Equity
The components of Equity Capital, in the case of Alpa Inc. and Beta Inc. are
- Common stock
- Retained earnings
- Other equity
Adding all the components, we get the Equity Capital value of
- Alpha Inc. = $100 + $120 + $80= $ 300
- Beta Inc. = $100 + $300 + $300= $ $700
Total Capital
We have already seen that,
Total Capital = Total Debt + Total Equity
- Alpha Inc. = $180 + $300 = $480
- Beta Inc. = $120 + $700 = $820
Now, we can calculate Debt to Capital Ratio for both the companies.
Calculating the Ratio
Debt to Capital Ratio= Total Debt / Total Capital
- Alpha Inc. = $180 / $480 = 37.5%
- Beta Inc. = $120 / $820= 14.6%
As evident from the calculations above, for Alpha Inc. the ratio is 37.5% and for Beta Inc. the ratio is only 14.6%.
What this indicates is that in the case of Alpha Inc. the company has around 37 % of its capital in the form of Debt while Beta Inc. has only 15% of its Capital via Debt.
Among both, Alpha Inc. has a significant Debt to Capital ratio.
This indicates that the company has a relatively higher Debt on its Balance Sheet.
Now, the company needs to meet its interest expense on its Debt Capital.
Since the company has high Debt, its Operating profit will be eaten away by high Interest expenses.
But, in the case of Beta Inc., the company has relatively lower Debt.
Hence, the company can earn better Operating profits that can be translated into pretax profit.
We will look at a detailed interpretation of the ratio in a later stage.
Debt to Capital ratio Using Excel
As part of the practical application, let us look at how to calculate the ratio using Excel.
In this example, we will consider the Financial Statement of Walmart.
Download the Debt to Capital template from the Marketplace
After download, you will receive the Consolidated Balance Sheet of Walmart along with related calculations.
As already highlighted, to calculate the ratio we need,
- Total Debt
- Total Capital
Total Debt can be calculated from the below Balance Sheet extract.
Total Debt
In the case of Walmart, the company has below items that form part of Debt.
- Short Term Debt
- Current Lease Obligations
- Long Term Debt
- Noncurrent Lease Obligations
Adding all the values, we get
Total Debt = $5,255 +$2,605 +$39,657 +$6,683 = $54,170
Now, to calculate Total Capital, also consider the below-given Balance Sheet extract showing Equity.
Total capital
We need to consider both Total Debt and Total Equity.
In the case of Walmart, components of Equity are as below.
- Common Stock
- Paid-up Capital
- Retained Earnings
- Other Equity
- Minority Interest
Adding all the values, we get
Total Equity = $288 +$2,965 +$80,785 -$11,542+ $7,138 = $79,634
Now,
Total Capital = Total Debt + Total Equity
=$54,170 + $79,634 = $133,804
Since we have all the values, we are now in the position to calculate the ratio for Walmart.
Debt to Capital = Total Debt / (Total Capital)
= Total Debt / (Total Debt + Total Equity)
=$54,170 / ($54,170 + $79,634)
= 40%
As evident, Walmart has 40% of its Capital funded via Debt.
Instead of concluding on a standalone basis, We need to look at how the Capital Structure has changed over the period.
This will help in analyzing the company better.
Debt to Capital ratio Interpretation
As already mentioned, the Debt to Capital ratio basically highlights the percentage of the company’s capital funded via Debt.
Let us look at how to interpret this ratio.
High Debt to Capital ratio
- If a company has a high Debt to Capital ratio, it indicates that the significant amount of the Company’s capital structure is funded via Debt.
- This will invariably lead to a higher Interest Cost.
- A high-interest cost will generally lead to lower profitability.
- Also if the company’s liquidity position is deteriorating, the company will find it difficult to meet its Interest Expense.
- If the company fails to meet its Interest Payment continuously, Lenders would worry about their capital. They may even ask for the repayment of capital if required.
- A low liquidity position and loan repayment request by the lender will further deteriorate the financial position of the Company.
- Since a high Debt to Capital ratio will result in lower Pretax Profit, it is considered as negative for Equity Shareholders.
Low Debt to Capital ratio
- If a company has a low Debt to Capital ratio, it basically indicates that the significant amount of the company’s Capital is funded via Equity.
- Since the ratio is lower, the company will have a relatively low Interest Expense.
- Under such a situation, the company’s Operating Profit will automatically translate into better Pretax profit.
- Also, having a low Debt to Capital ratio is considered positive to the Equity Shareholders.
- In the future, for any Business Expansion, the company will have the flexibility to raise the funds via Debt instead of Equity as the ratio is relatively lower.
Trend Analysis
As already highlighted, to analyze the company better, we need to look at how the ratio has moved over the periods.
This will help in understanding the change in Capital structure and the Company’s strategy towards raising Capital.
Let us understand how the Capital structure of Apple has changed over the period.
Consider the below-given chart that shows the ratio profile for the past 5 years.
As evident from the chart above, back in 2015, the company had only 35% of its Capital funded via Debt.
But, subsequently, the share of Debt in the overall capital Increased significantly.
So, the company has raised the additional capital via Debt that made the ratio Increase
Currently, for the year ending 30th June 2019, the Debt to Capital ratio for Apple is 55%.
Also, it is important to understand that raising additional funds via debt should not be concluded as a bad strategy.
If a company is earning sufficient return which is greater than the Cost of Debt, then raising additional capital in the form of Debt is more beneficial for the company.
This may be relevant in the case of Apple.
Since the company earns a return which is greater than the Cost of Debt, the company prefers raising additional funds via Debt rather than Equity.
Hence, analyzing the historical ratio helps us in understanding the company strategy around its capital structure.
Comparison With Similar Companies
In this section, let us quickly look at the ratio profile for prominent companies.
This will help us understand how different the ratios are when compared to one another.
Internet-based companies.
As evident from the chart above, internet-based companies like Facebook and Google have a very nominal Debt on their Balance Sheet. Most of their Capital is in the form of Equity.
Hence, the Debt to Capital ratio for both these companies is very low.
In the case of Facebook, the company does not have any Debt. Hence, the Debt to Capital ratio would not be relevant here.
In the case of Google, the company has very nominal that the Debt to Capital ratio for Google is as low as 2%
Oil and Gas company
Let us look at the ratio profile for ExxonMobil-US based Oil & Gas company.
Even this company does not have any significant Debt on its Balance Sheet.
ExxonMobil Debt to Capital ratio is around 16%
Retail company
As already discussed as part of the example above, Walmart has around 40% of its capital funded via Debt.
To understand if this is a Good Debt to Capital ratio or note, we to look at how the Capital Structure has changed over the period. Similar to what we did for Apple (Refer this)
Microsoft
Similar to Walmart, Microsoft has a ratio which is around 45%.
Unlike other internet-based companies like Facebook and Google, Microsoft has borrowings on its Balance Sheet.
Hence, the company has a Debt to Capital ratio which is higher than companies like Google and Facebook.
Amazon
Let us look at another Internet-based company- Amazon.
As part of its expansion strategy, the company requires significant Additional Capital periodically.
Currently, the Debt to Capital ratio for Amazon is 53%.
Apple
The premium smartphone maker Apple also has considerable Debt on its Balance Sheet.
As already seen as part of the Trend Analysis, the company’s strategy has been raising additional Capital in the form of Debt.
Hence, clearly the ratio has significantly shot up over the period.
Currently, the Debt to Capital ratio for Apple is 54%.
Tesla
Tesla is a US-based automobile company predominantly manufacturing electronic vehicles.
When we compare other companies in the chart above, clearly Tesla has the Highest Debt to Capital ratio.
The company has been suffering losses for many years depleting the capital rapidly.
Recently, the company raised capital via convertible Debt.
Since the company has been making losses, the Equity value on the Balance Sheet relative to the Debt Capital has decreased significantly.
Hence, the Debt to Capital ratio for Tesla is as high as 65%.
Although the ratio is significantly high, Investors and lenders are optimistic about the companies future prospects. Hence they are ready to fund the company constantly.
Conclusion
So that was everything we need to know about the Debt to Capital ratio as part of Liquidity Ratios.
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