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There are several reporting options to evaluate your small business’s financial health. One widely used option is the debt-to-capital ratio (D/C ratio) analysis, which shows how much debt your business has relative to its total capital. This is an important metric because it can help pinpoint financial problems that you might not know your company has. For example, you could exceed sales goals and generate huge profits but be saddled with excess debt, increasing the risk of future bankruptcy.
Understanding the debt-to-capital ratio is essential for making informed decisions about your business relating to finances and investments. It is also a helpful metric to examine if you ever want to acquire or invest in another company. This Balboa Capital blog article has the necessary information, including the steps to calculate this important metric and tips on how to use it effectively. The article also features tips on how to improve a D/C ratio.
What is a debt-to-capital ratio?
As mentioned earlier, the debt-to-capital ratio is a vital reporting metric that measure’s a company’s leverage. In a nutshell, it compares a company’s total financial obligations to its total amount of capital. As a result, this ratio provides business owners with valuable information about their company’s financial situation that can be used to make investment, budgetary or operational changes if required.
For example, a business with a high debt-to-capital ratio uses a high amount of debt to finance its operations. As a result, the company is at risk of financial trouble, including liquidity issues and bankruptcy. So, the company’s owner would need to determine ways to manage debts effectively and reduce the ratio.
Debt-to-capital ratio formula.
You will be glad to know that calculating the debt-to-capital ratio is very easy if your company’s financial books are accurate and updated. To see your business’s ratio, divide your total debt by the sum of your business’s debt and shareholder equity. Debt comprises your short- and long-term liabilities, and shareholder equity is the entire company equity (common and preferred stock, minority interest).
To illustrate the formula, let’s use a manufacturing company as an example. The manufacturing company has $1.25 million in debt and $5.75 million in shareholder equity, so the calculation is as follows:
$1.25 million/$1.25 million + $5.75 million ($7 million) = 0.178 (a 17.8% debt-to-capital ratio)
The result of this example indicates that 17.8% of the manufacturing company’s overall operations are funded using its existing debt instead of its existing capital. 17.8% is a low ratio. The manufacturing company’s income is high enough to cover its debt and other business-related liabilities. Plus, the company’s 17.8% debt-to-capital ratio presents it with future investment opportunities that require minimal equity financing.
Low versus high ratios.
It would be best to strive to maintain a low debt-to-capital ratio. The benefits of having a low debt-to-capital ratio include increased access to financing with favorable interest rates and terms, more efficient use of capital, and improved creditworthiness. Conversely, a high debt-to-capital ratio can be extremely risky for your business. This is because your company has borrowed a large amount of money to finance its operations and investments and is now at risk of being unable to pay back the debt. As a result, a high debt-to-capital ratio can lead to higher interest costs, reduced liquidity, and increased financial risk.
In terms of actual ratios, you might be wondering what low and high ratios are in percentages. In the example we feature in the section above, the manufacturing company had a 17.8% ratio, which is considered favorable because it is low. On the other hand, if the manufacturing company’s ratio is close to 50% or higher than 50%, that is a sign that it has far more debt than equity, which is unhealthy for the company.
How to improve your ratio.
In a perfect business world, your company would see continuous sales revenues and profits throughout the year, and some of the profits can be set aside to pay off your debt. But we know that is only sometimes the case, or it may only happen during specific times of the year. That said, there are steps you can take to improve your debt-to-capital ratio.
To begin with, you can look at ways to reduce your debt. For example, if your company has a high-interest-rate loan, contact your bank or lender to inquire about their refinance options. In addition, if you have more than one outstanding loan, consider consolidating them into one loan, so you make fewer payments and pay less interest.
Next, if your business has inventory that isn’t selling, it might be time to run a sale. Purchasing excess inventory can deplete your cash flow, increase debt, and take up storage space.
An excellent debt-to-capital ratio is essential for any business because it indicates financial health and stability. In addition, it helps to measure the amount of debt that is held by a company relative to its total assets. By improving your business’s debt-to-capital ratio, you can reduce its leverage ratios and ensure that it has enough cash flow and working capital to cover its liabilities.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.