What it means
A company's capital is the money invested in it for the long term: what shareholders have put in and left in, and what lenders have lent. The debt-to-capital ratio asks what share of that capital is borrowed.
It differs from the debt ratio, which divides liabilities by total assets and so includes trade creditors and other operating liabilities, by focusing on financing rather than operations: only interest-bearing debt counts as debt, and only debt plus equity counts as capital. The result is a cleaner measure of the financing decision the company has made, uncluttered by the payables and accruals that arise from trading.
The ratio has a natural range of zero to 100%. A company with no borrowings is at zero; a company whose equity has been wiped out by losses is at or above 100%.
Most trading companies sit between 20% and 60%. Where a company should sit depends on the stability of its cash flows, the nature of its assets and the attitude of its owners.
Utilities and infrastructure companies with predictable revenues run at 50% to 70%; technology and service businesses with volatile earnings and few tangible assets run below 30%; private equity owned companies run high ratios deliberately, because leverage magnifies returns to the equity and the owners accept the risk. The ratio is closely related to the debt-to-equity ratio, and one can be converted to the other: a debt-to-capital ratio of 40% is a debt-to-equity ratio of 0.67 (40 / 60), and a debt-to-equity ratio of 1.0 is a debt-to-capital ratio of 50%.
The debt-to-capital ratio is bounded and intuitive as a percentage; the debt-to-equity ratio is unbounded and rises steeply as equity shrinks. Analysts use both, and the choice is often a matter of convention in the industry or the loan agreement.
Two refinements are common. Net debt, which deducts cash and equivalents from gross debt, gives a ratio that reflects the company's true reliance on borrowing when it holds significant cash; a company with $30,000,000 of debt and $25,000,000 of cash is barely leveraged in substance.
Market values, which replace book equity with the market capitalisation of the shares, give a ratio that reflects what investors think the equity is worth rather than what the accounts record; for valuation purposes and for the weighted average cost of capital, market weights are the correct ones, because they represent the proportions in which investors have actually committed capital at current values. The ratio's most important application is in the cost of capital.
A company's weighted average cost of capital is the after-tax cost of its debt weighted by the debt proportion plus the cost of its equity weighted by the equity proportion. The debt-to-capital ratio supplies the weights.
Since debt is cheaper than equity, a higher ratio lowers the weighted cost, up to the point at which the added risk raises both the cost of debt and the cost of equity by enough to offset it. Boards that manage to a target debt-to-capital ratio are, in effect, managing to what they judge to be the minimum cost of capital consistent with a survivable level of risk.
In practice
Real-world examples.
Example
A regulated electricity distributor maintains a debt-to-capital ratio of 60%, in line with the level its regulator assumes when setting allowed returns, and issues bonds or equity to stay near it.
Example
A software company with $200,000,000 of cash and no borrowings has a debt-to-capital ratio of zero, and its board debates whether a modest level of debt would lower its cost of capital.
Example
A company's book debt-to-capital ratio is 45% but its market ratio is 20%, because its shares trade well above book value; its lenders use the book figure, its valuers the market one.
Think of it
“Debt-to-capital is like measuring what percentage of your home purchase came from a mortgage versus your down payment.
Formula
Calculation
Debt-to-capital ratio = Interest-bearing debt / (Interest-bearing debt + Shareholders' equity)
Net debt-to-capital ratio = (Interest-bearing debt minus Cash) / (Interest-bearing debt minus Cash + Shareholders' equity)
Market-value version: replace book equity with Market capitalisation
Conversion: Debt-to-equity ratio = Debt-to-capital / (1 minus Debt-to-capital)
Weighted average cost of capital = Debt weight x After-tax cost of debt + Equity weight x Cost of equity
Worked example. A company has interest-bearing debt of $30,000,000, cash of $5,000,000 and book equity of $45,000,000. It has 10,000,000 shares trading at $9. Its pre-tax cost of debt is 6%, its tax rate 25% and its cost of equity 10%.
- Debt-to-capital (book) = $30,000,000 / ($30,000,000 + $45,000,000) = 40%
- Net debt-to-capital (book) = $25,000,000 / ($25,000,000 + $45,000,000) = 36%
- Market capitalisation = 10,000,000 x $9 = $90,000,000; debt-to-capital (market) = $30,000,000 / ($30,000,000 + $90,000,000) = 25%
- Equivalent debt-to-equity ratio (book) = 40% / 60% = 0.67
Cost of capital. After-tax cost of debt = 6% x (1 minus 0.25) = 4.5%.
- On book weights: 40% x 4.5% + 60% x 10% = 1.8% + 6.0% = 7.8%
- On market weights: 25% x 4.5% + 75% x 10% = 1.125% + 7.5% = 8.6%
The market-weighted figure is the one to use for valuing the company or appraising its investments, because it reflects the proportions at which capital is actually held at current values.
Effect of a buyback. The board considers borrowing $10,000,000 to buy back shares. Debt would rise to $40,000,000 and book equity fall to $35,000,000: debt-to-capital = $40,000,000 / $75,000,000 = 53%, above the board's 50% policy ceiling. The board limits the buyback to $6,000,000: debt $36,000,000, equity $39,000,000, ratio 48%.Case study
Seen in the real world.
A private equity firm bought a packaging company for $100,000,000, financing the purchase with $60,000,000 of debt and $40,000,000 of equity: a debt-to-capital ratio of 60% at completion, and debt of five times the company's EBITDA of $12,000,000. The structure was designed to magnify the equity return: if the company could repay half its debt from cash flow over five years and grow EBITDA to $16,000,000, an exit at eight times EBITDA would give an enterprise value of $128,000,000, and after repaying the remaining $30,000,000 of debt the equity would be worth $98,000,000, nearly two and a half times the $40,000,000 invested.
The plan wobbled in the second year, when a major customer moved to a competitor and EBITDA fell to $9,000,000. Debt was still $54,000,000, so debt to EBITDA had risen from 5.0 to 6.0 times and the debt-to-capital ratio, with equity written down in the accounts for the lost profits, was over 65%.
The lenders' covenant was breached, the cash sweep captured all free cash flow, and for eighteen months the owners could neither take money out nor invest in the business. The firm negotiated a covenant reset, injected $5,000,000 of new equity to demonstrate commitment, and replaced the management team.
The company recovered. By year five EBITDA was $15,000,000, debt had been reduced to $34,000,000, and the exit at 7.5 times gave an enterprise value of $112,500,000 and equity of $78,500,000 against $45,000,000 invested: a good return, but well short of the plan, and one that had come close to being zero.
The firm's post-investment review concluded that the initial 60% debt-to-capital ratio had left no room for a single lost customer, and its subsequent deals in cyclical sectors were struck at 50%. The lesson was not that leverage is bad but that the ratio at which it becomes dangerous depends on how far the cash flows can fall, and that the buyer who sets it at the edge of survivability is betting that nothing goes wrong.
Watch out
Common mistakes.
- Including trade payables and other operating liabilities in "debt", which confuses the debt-to-capital ratio with the debt ratio and overstates leverage.
- Using book equity for cost-of-capital weights when the shares trade far from book value; market values reflect the proportions at which investors have actually committed capital.
- Ignoring cash; a company with large cash balances is less leveraged than its gross ratio suggests, and the net debt version shows it.
Questions
People also ask.
What is the difference between the debt-to-capital ratio and the debt-to-equity ratio?
Both compare debt with equity, but debt-to-capital expresses debt as a share of the total (debt plus equity) and is bounded between zero and 100%, while debt-to-equity expresses debt as a multiple of equity and is unbounded. They convert directly: 40% debt-to-capital equals 0.67 debt-to-equity.
What is a good debt-to-capital ratio?
It depends on the stability of the business. Below 30% is conservative; 30% to 50% is typical for established trading companies; above 60% is high and normal only for utilities, property and leveraged buyouts.
Why does the ratio matter for the cost of capital?
Because it sets the weights. Debt is cheaper than equity after tax, so a higher ratio lowers the weighted average cost, until the added risk raises the cost of both. The optimal ratio is where the weighted cost is lowest, and boards set target ratios with that in mind.
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