How does your business finance operations? The debt-to-capital ratio can tell you exactly that. Helping you to understand your business’s capital structure, solvency, and degree of financial leverage, it can be an important metric for business owners and investors to get to grips with. Find out more about debt-to-capital ratio analysis with our comprehensive article. First, what is the debt-to-capital ratio?
Debt-to-capital ratio definition
The debt-to-capital ratio (D/C ratio) measures the financial leverage of a company by comparing its total liabilities to total capital. In other words, the debt-to-capital ratio formula measures the proportion of debt that a business uses to fund its ongoing operations as compared with capital. This financial metric can help you understand a range of things about your business, including capital structure and financial solvency. So, if you want to understand how well your business could handle a potential downturn in sales revenue, debt-to-capital ratio analysis could be ideal.
What is the debt-to-capital ratio formula?
There’s a simple debt-to-capital ratio formula you can use to work out this financial ratio:
Debt-to-Capital Ratio = Debt / Debt + Shareholder’s Equity
As you can see, it’s a relatively simple calculation – all you need to do is divide your firm’s total debt by its total capital (total debt + shareholder’s equity).
It’s important to make note of a couple of points when it comes to the debt-to-capital ratio formula. “Debt” includes all short and long-term liabilities, while the “shareholder’s equity” figure should be a sum of all company equity, from common and preferred stock to minority interest.
If that all sounds too complicated, don’t fret – there are a wide range of online debt-to-capital ratio calculators that you can use to work out your D/C ratio, rather than calculating it by yourself. All you need to do is plug in your figures and the debt-to-capital ratio calculator will do the rest.
Debt-to-capital ratio example
Now, let’s look at an example of the debt-to-capital ratio to see how it works in practice. Imagine that Company A lists $40,000,000 in short-term liabilities and $70,000,000 in long-term liabilities on their balance sheet. They’ve also issued $20,000,000 in preferred stock, $5,000,000 in minority interest, and have around 8,000,000 outstanding shares trading at $10 per share. Using all that information, you can complete the debt-to-capital ratio formula like so:
Debt-to-Capital Ratio = ($40M + $70M) / ($40M + $70M) + ($20M + $5M + (8M x $10)) = 0.512
In other words, 51.2% of Company A’s operations are funded with debt, rather than capital. This makes it a relatively risky proposition, as the business is aggressively financing growth activities with debt.
Using debt-to-capital ratio analysis
At its core, the debt-to-capital ratio is a measure of risk. Financing your business’s day-to-day operations through debt has an intrinsic level of risk, because the principal (plus interest) must be paid back to the lender. As a result, firms with a higher debt-to-capital ratio are inherently riskier prospects, as a downturn in sales could lead to potential solvency issues. Having said that, a higher debt-to-capital ratio isn’t always a negative. If the loans are used in the right way, it could lead to sizable returns for shareholders.
Limitations of the debt-to-capital ratio
It’s also important to think about the limitations of debt-to-capital ratio analysis. In some senses, this financial metric will be affected by your company’s accounting practices. This is because entries on your financial statements are likely to be based on historical cost accounting, rather than their current market values. If you use these entries to draw a debt-to-capital ratio interpretation, they may not accurately reflect your business’s true financial leverage. As such, it’s incredibly important to use the correct values when running a debt-to-capital ratio analysis.
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