Understanding Debt to Capital Ratio
A Debt to Capital Ratio is a solvency metric that measures the company's ability to meet its debt obligations through its total capital or the portion of the debt compared to its total capital. It indicates the company's capital structure and how well it is financing its capital. It is calculated by dividing total debts by the sum of total debts and shareholders' equity, which is known as total capital.
The formula to derive Debt to Capital Ratio
Total Debt -
It is a sum of the company's long-term debts and short-term debts. And it is found in the company's liabilities section of the Balance Sheet.
Total Equity -
It refers to the equity amount which belongs to the company's shareholders or owners' claim on the assets after settlement of debts. It is also known as Shareholders equity, and it is found in the Balance Sheet.
Total Capital -
It is a sum of the company's total debts and total shareholders' equity. Both of these factors are found in the company's Balance Sheet.
Example of Debt to Capital Ratio:
For the financial year, Dixon Technologies (India) Limited reported Total Debt as Rs. 151.92 Cr. and Total Equity as Rs. 889.22 Cr.
The value as per the formula (Total Debt / Total Debt + Total Equity) is calculated as (151.92 / 151.92 + 889.22) = 0.17.
A Debt to Capital Ratio measures the portion of the debt compared to its total capital.
The debt to capital ratio is calculated by dividing total debts by total capital. Total capital is the sum of the company's total debts and shareholders' equity.
Generally, a low debt to capital ratio is considered good as it indicates that a large portion of the company's capital is acquired by equity compared to debt.
While looking at the Debt to Capital Ratio, the following points should also take into consideration:
A low debt-to-capital ratio shows that the company's total capital contains minimum borrowed funds and more equity capital. Generally, the debt to capital ratio below 0.5 is considered good.
If the debt to capital ratio is 0.5, then it means the company shareholder
A high ratio indicates that a large portion of a company's capital is financed by debt rather than equity. It shows the weak financial position or strength of the company. But the companies with a high ratio are acceptable if their cash flow is stable or the interest coverage ratio is over 3, but the debt to capital ratio should be less than 0.75. High debt is not acceptable for companies with unstable cash flows.
In contrast to other companies (like IT and services), capital-intensive companies' debt-to-capital ratio can be higher. Companies with capital-intensive operations require large amounts of funding to invest in assets or projects, so their debt levels also tend to be high.
As economic factors or market conditions affect companies, and they are facing challenges, then companies with a low debt to capital ratio may survive better than a company with a high ratio.
How to use the Debt to Capital Ratio effectively
Investors should look for companies with a debt to capital ratio below 0.5. It indicates that a large portion of the company is acquired by equity.
While doing analysis, also looks at the company's historical data to understand past performance. It is a positive sign if the debt to capital ratio is decreasing over a year as it indicates that the company is reducing its debt or financing more equity capital.
Companies that operate in software, financial, service, etc., are most likely to have a low debt to capital ratio compared to capital-intensive companies.
In order to get a better analysis, we cannot rely on a single ratio. Thus, the Debt to Capital Ratio should be used in conjunction with other financial metrics, such as Debt to Equity Ratio
, Debt to Assets
, CFO to Debt
||Debt Free Capital
|0.1 to 0.3
||Almost Debt Free Capital
|0.3 to 0.5
|| Mild Bullish
||Low Debt Capital
|0.5 to 1
||Adequate Debt Capital
|1 to 1.5
|| Mild Bearish
||Sufficient Debt Capital
|1.5 to 2
||Surplus Debt Capital
|| Strong Bearish
||Excessive Debt Capital