What it means
Capitalisation is the total long-term money invested in a business, which is its debt plus its equity (the owners' stake). The total debt-to-capitalisation ratio asks what portion of that pool is debt, so a result of 40% means that 40 cents of every dollar of long-term funding is borrowed.
It is one of the most common leverage measures in credit analysis and is often written into loan agreements as a covenant, for example a promise to keep the ratio below 60%. Bondholders and banks watch it because debt must be paid whatever the profits, while equity is not.
The ratio is similar to debt to equity but is easier to compare, because it is always between 0% and 100% as long as equity is positive. A company with $1 of debt and $1 of equity has a ratio of 50% and a debt to equity ratio of 1.0, and the two measures move together.
Definitions differ, so it is vital to check what counts as debt. Some analysts include only bank loans and bonds, others add finance leases and pension deficits, and some add all liabilities, and the equity figure may be book value or, less often, market value.
For management, the ratio helps in deciding how to fund investments. If it is already high, the company may prefer to issue shares or retain profits, while a low ratio suggests room to borrow cheaply and perhaps improve returns to shareholders.
Interpretation depends on the industry and on the stability of cash flows. A utility with predictable income can carry a much higher ratio than a start-up with uncertain sales, and equity can turn negative after large losses or buybacks, which makes the ratio hard to read.
In practice
Real-world examples.
Example
A packaging manufacturer has $12,000,000 of debt and $18,000,000 of equity. Its ratio is 12 / 30 = 40%, comfortably below the 55% limit in its bank facility.
Example
A telecom operator with heavy infrastructure spending has $90,000,000 of debt and $60,000,000 of equity, a ratio of 60%. Credit analysts accept this level because its subscription revenue is steady and predictable.
Example
A founder-owned design agency has $200,000 of debt and $1,800,000 of equity, a ratio of 10%. A potential buyer notes that the company is conservatively financed and could support a larger loan to fund the purchase.
Formula
Calculation
Total Debt-to-Capitalisation Ratio = Total debt / (Total debt + Shareholders' equity)
Suppose a company has $400,000 of bank loans and bonds and $600,000 of shareholders' equity. Total capitalisation = 400,000 + 600,000 = $1,000,000. Ratio = 400,000 / 1,000,000 = 40%. If the company then borrows another $200,000 to buy equipment, debt rises to $600,000 and the ratio becomes 600,000 / (600,000 + 600,000) = 50%.Case study
Seen in the real world.
Fairhaven Foods is an illustrative, fictional distributor with $15,000,000 of debt and $25,000,000 of equity, giving a ratio of 15 / 40 = 37.5%. Its bank loan agreement carried a covenant that the ratio must stay below 50%.
After a poor harvest year the company reported a loss of $6,000,000, which cut equity to $19,000,000, and it also borrowed $3,000,000 to fund inventory. Debt rose to $18,000,000, so capitalisation became $37,000,000 and the ratio climbed to 18 / 37 = 48.6%, only just inside the covenant.
The finance director opened talks with the bank early and agreed to suspend dividends and sell an unused warehouse for $4,000,000, using the proceeds to repay debt. The illustrative lesson is that losses reduce equity and so push the ratio up twice, once through the numerator and once through the denominator, which is why companies should monitor covenant headroom well before a breach. Fairhaven now reports the ratio each month, shows a forecast for the next four quarters and keeps a written plan of the actions it would take if headroom fell below five percentage points.
Watch out
Common mistakes.
- Dividing debt by equity alone and calling the result the debt-to-capitalisation ratio, which gives a different and larger number.
- Forgetting to include short-term borrowings and the current portion of long-term debt, which understates the ratio.
- Using the ratio when equity is negative, which makes the percentage meaningless or above 100%.
Questions
People also ask.
What is a good debt-to-capitalisation ratio?
It varies by industry, but many lenders become cautious above 50% to 60% for ordinary companies, while stable utilities may sit higher.
Does a high ratio always mean financial trouble?
No, because strong and predictable cash flows can support a lot of debt, but it leaves less room for error if earnings fall, and lenders usually respond by charging a higher interest rate or asking for tighter covenants.
How does the ratio relate to the debt to equity ratio?
Debt-to-capitalisation equals debt to equity divided by one plus debt to equity, so a debt to equity of 0.5 corresponds to a ratio of 33.3%.
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