Debt to Capital Ratio

There are many investors all over the world who invest finances into the securities and share markets. These investors often tend to use different tools and techniques in order to forecast and predict returns over their investment. This process is often termed as balance sheet analysis or financial leverage of a company.

This ratio can be used to determine the financial leverage and financial position of a business or even an individual. The term 'leverage' basically implies the total financial net worth of a company, its predicted growth, and also its reputation in terms of goodwill in the market.

We can figure out the meaning of D/C ratio very easily by just referring to the term itself.

• Debt: This term implies the amount of money that a business owes to its creditors. There are different types of debts that a business can have, such as loans, credit extensions from suppliers, installment payments for fixed assets, mortgage loans, credit cards, etc.

In short, it constitutes all long-term and short-term obligations of the company.

• Capital: It is any kind of money invested in order to run the business. The sources with which the capital for every business organization is raised can be different. The D/C ratio is drastically affected as a result. 

The capital usually consists of the total amount invested, fixed assets (which are not secured as collaterals), other investments by investors, common stock, and net debt as well.

The calculation of this ratio is extremely simple, though much more complex formulas have been derived by businesses for their own convenience. You can use the following formula for the purpose of simple calculation:

Debt to Capital Ratio: Total debts that are to be paid or are payable ÷ Total capital Invested + Debt

This formula gives you a two-sided ratio, such as 2:3, which might not prove to be exactly resourceful, in some cases. In such cases, you may also convert the ratio into a percentage. For this purpose, multiply the fraction by 100. According to the ratio 2:3, the total liabilities payable would become 66.66% of the total capital.

There are different variants of this ratio. The above variant, where the ratio is expressed in a percentage, is one such prominent example. While using this variant of the formula, it is also possible that the output figure tallies up to some weird figure such as 200%.

Such figures that exceed 100, indicate that the total debt or liabilities exceed the amount of capital. As mentioned above, the nature of the business organization affects the formula as well as output of the calculation.

Thus, if you are calculating this ratio of a businessman, or a sole trading concern, you will need to simply divide the amount of debt with the capital. In such a case, you will see that debt is very low and never exceeds the amount of capital.

The same variant of the formula is applicable to partnership firms as well. In contrast, large joint stock companies are bound to have larger ratios, with debt exceeding the capital. Joint stock companies also include all share amounts in the capital (which in reality is debt), or different amounts of capital supplied by finance organizations.

There is no set of concrete recommendations for this ratio. Thus, the best way to analyze this ratio is to have a look at the constituents of the ratio. There are many companies who consider insurance payments as debt in calculation of this ratio. Some businesses also include prepaid expenditures as capital in the ratio.

In general, as a thumb rule, the best financial management and financial planning is observed when the debt is lesser than the capital. In cases of joint stock companies, an equal ratio is much better, as it depicts a very good use of loan and credit facilities.

The ratio of debt and capital provides a measure of the extent to which an organization funds itself on debt financing, and also indicates the amount of risk to its stockholders.