What is a debt to capital ratio Definition?
Debt to capital is the liquidity ratio which calculates the use of a company’s financial leverage by comparing its net obligation to the net capital.
This ratio mostly uses for the measuring of the risk and allow us that from this we can calculate how a firm or company handle efficiently the downturn in the sale.
This ratio used for the highlight of debt to equity financing relation. this is very risky that anyone does the financing operation through the loans career because in this case, this is a must that repaid the principal and interest to the lender.
So the company which has a high ratio is considered as the company at most risk. Because for high ratio company, it is necessary that to maintain the same sales to maintain their debt servicing obligation. If the level of sales down of the high ratio company then there will be the solvency ratio.
Also, debt loan financing has many positive points for the abnormal to return into shareholder if loan use efficiently. For example, as compare to the cost of debt – shareholder return increase company earn more.
For the measurement of financial risk on the base of financial structure investor mostly use debt to capital ratio. If the ratio is high then it means that the company extensive using debt to finance its operation. But if the ratio is low then it means that the company raises its funds through company shareholder or current revenue.
When we divide the total debt of the company by sum of total debt and shareholder equity then we get the debt to capital ratio. that is
In the above equation, total debt represents the total liabilities of the company and shareholders equity represent the total equity of the company like preferred stock, common stock, and minority interest.
Now we apply an example at the above formula.
Let we consider 2 company that is company A and company B. Total asset of the company A is $300M. Short term liability of the company is $30M and long term liability is $45M. The preferred stock of company A has worth $25M with $2M interest. $10M share of company trade at $15 per share. Calculate the Debt to Capital ratio of company A.
Now from the balance sheet of the company B if we calculated from the value
then the result calculated is bad Because the financial risk for company B is high. So for the investor company A is the best choice for investment.
Debt to the capital ratio used for the financial risk to lender and shareholder measuring. If the ratio is high then the risk will be greater but mostly it not occur. The high ratio does not mean that it is bad. If we use the example of the utility company which has high debt to capital ratio but it does not mean that the utility company is soon insolvent. Revenue of the utility company is consistent. which means that it wants to meet the obligation and not worry about the revenues downturn.
If the debt to capital ratio of the firm or company is greater then 1 then it is not good because debt is greater then capital which is risky for the company. Without an increase in earning if the company acquire more liabilities then there may go bankrupt.
If the debt to capital ratio is low then the company at low risk and debt of the company more then the capital. Investor gives priority to this company for investment.
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