Your business can only succeed in a fiercely competitive marketplace if it has a firm grasp on its financial resources. Therefore, before making any significant financial decisions, as a business owner, you should have a solid grasp of your company's total capital structure, solvency, and level of financial leverage.
Several accounting ratios can tell business owners, investors, and others about the state of a company's finances. One such accounting ratio is the debt-to-capitalization ratio.
The debt-to-capital ratio is a useful indicator of your company's financial health. If you understand how to compute and interpret this ratio, you'll be able to sustain your long-term strategy better and attract investors.
In this piece, we'll discuss the debt-to-capital ratio and how to interpret its results. First, what is the debt-to-capital ratio?
What is the debt to capitalization ratio?
The debt-to-capital ratio evaluates how much debt a company has compared to its overall capital. Simply put, this ratio measures the proportion of your company's finances that are covered by debt as opposed to capital.
The debt capital formula can assist you in comprehending your company's total capital structure and financial soundness, among other things.
Significance of debt to capital ratio
- Cash-flow analysis: The debt-to-capital ratio may help determine if your business can pay off the loans' interest and still have money left over for further expenditures like R&D or acquisitions.
- Debt service analysis: This ratio will also show whether your business has too much debt and should consider selling off the company's assets to lower its financial obligations and bring this ratio back to par.
- Benchmarking: As a manager or owner of a firm, you can compare your company's debt-to-capital ratio to the industry standard.
Debt to capitalization formula and calculation
There exists a straightforward method for calculating the debt-to-capital ratio:
Debt to capital ratio: Total Debt/Total Capital
Total debt: Total debt is the amount of borrowed funds your company owes. It is determined by putting your long-term and short-term debts together.
Total capital: Total capital comprises of shareholder equity, which includes ordinary stock, preferred stock, and minority interests, plus all the debt.
Debt to capitalization calculation for XYZ Limited
Short-term debt: (Accounts Payable, Wages, Salaries, Interest Payments, etc.) $60,000
Long-term liability: (Long Term Loans, Capital Leases, Debentures, etc.) $240,000
Common stock: (A common stock represents a portion of a company's ownership and confers voting rights) $3,60,000
Preferred stock: (Preferred stock is a form of stock that provides dividends but lacks voting rights) $1,50,000
Minority interest: (Shareholding in a firm with a bigger parent company owning the majority of the shares) $90,000
Total debt: $60,000 + $2,40,000 = $300,000
Total capital: $60,000 + $2,40,000 + $3,60,000 + $1,50,000 + $90,000 = $900,000
Debt to the total capital ratio: $300,000/$900,000 = 0.33
In other words, 33.33 percent of Company XYZ's activities are financed by debt instead of equity. This makes it a moderately risky venture since around one-third of the company's operations are financed by debt.
Debt to capital ratio interpretation
The debt-to-capital ratio is an indicator of risk. There is always a greater risk involved in using debt financing for to fund operations since the debt must be repaid in full (principal + interest).
Hence, reduced cash flow raises the probability of default if emergency funds are depleted before debts are paid. As a result, your business may have difficulty obtaining new loans from financial institutions to keep the company's operations afloat until sales improve.
Companies with a high debt-to-capital ratio are riskier investments since a dip in sales might threaten their ability to pay off their debts.
What is a good debt-to-capital ratio?
Which is preferable, the debt-to-capital ratio high or low? In most cases, the debt to total capital ratio exceeding 0.6 indicates that a company has much more debt than equity. XYZ Ltd., as seen above, had a debt-to-capital ratio of just 0.33, meaning they had room to expand their borrowing should the need arise.
If your company's debt-to-capital ratio is close to or equal to 1, it has no equity financing and operates mostly on debt. This is a huge gamble. Your business might go bankrupt if you keep piling on debt without corresponding revenue growth.
Still, a high debt-to-capital ratio isn't necessarily a bad thing. The appropriate use of debt might provide substantial profits for your company's investors since they can enjoy better dividends.
For example, a startup can have a larger debt-to-capital ratio while it works to establish its clientele and expand its business. Businesses that want to transition away from debt eventually may use a combination of debt and equity financing to get them through the startup phase.
Therefore, if your firm has a high debt-to-capitalization ratio, you must consider your business proposition, competition analysis, industry, and other critical variables. If you can pay the debts well in time, you may be in a sweet spot for growth.
Limitations of debt to capitalization ratio
Like with everything, the debt to capital ratio has its disadvantages. Here we take a look at some downsides of using this ratio:
Debt to capitalization is impacted by several factors, including how your firm accounts for its debt. This is because the values recorded in your financial statements, more often than not, reflect their historical cost rather than their current market worth.
Your company's actual financial leverage may differ from what you infer from these data if you employ debt-to-capital ratios. The accuracy of a debt-to-capital ratio study relies heavily on using actual figures.
As a measure of financial leverage, the debt-to-capital ratio tends to benefit organizations and industries that do not depend substantially on debt.
Meanwhile, young and fast-developing firms and sectors may bear a high debt-to-capitalization ratio due to aggressive expenditure on customer acquisition, R&D, marketing expenses, etc.
Since the debt-to-capital ratio varies widely from sector to sector, comparing them is difficult. Different businesses and financial statements and structures will result in different ratios. Ratios that seem high to you are rather average for another industry.
Therefore, monitoring the debt-to-capital ratio with industry standards is essential while assessing a company's financial health.
The bottom line
Whether you're trying to attract investors to your business or get a sense of how stable its finances are, the debt-to-capital ratio is an easy yet useful financial metric to use. Use the debt-to-capital ratio and other key financial ratios to obtain a holistic financial health analysis of your business.