Debt to Capital Ratio | Debt Ratio | FIN-ED
Debt-to-capital ratio formula
A debt-to-capital ratio formula could be advantageous for business owners or operators when used in financial reports. The formula for calculating the D/C ratio is:
Total debt / (total debt plus shareholders equity) equals the debt-to-capital ratio.
The D/C ratio can be found on your company’s balance sheet. A higher ratio or percentage typically denotes that the business assumes a greater level of risk. For instance, if a business borrows money to fund its operations, it repays the loan with its profit. The ability to repay loans is affected if the company’s profits decline, which increases the risk.
What is the debt-to-capital ratio?
The debt-to-capital ratio, also known as the D/C ratio, gauges the proportion of debt a business uses to finance its operational and functional costs as opposed to capital. Capital comprises the assets and cash a business has. The D/C ratio measures the risk a company takes with regard to debt and its overall financial operation.
Business owners and finance teams can gain a better understanding of their company’s capital structure and financial competency by calculating a company’s D/C ratio. The formula generates a percentage that expresses the amount of risk a business is willing to take with its financial operations. Increased leverage and risk result from higher percentages. This indicates that the business has more debt than equity or revenue. A company is at risk if it has more debt than capital because it will have less of its own funding to support the business during a tough time.
How to calculate the debt-to-capital ratio
Here are the steps for calculating the D/C ratio:
1. Gather all relevant data
It’s crucial to compile financial records, previous reports, receipts, and other pertinent financial documents before calculating the D/C ratio. These assist you in calculating the accurate amount of your overall debt. Additionally, the shareholders equity—the sum that a company’s owners have contributed or accrued over time—is disclosed in these documents. Relevant data includes:
2. Input numbers into the formula
Put the figures representing the company’s debt and shareholders’ equity into the formula after you’ve calculated them. It’s crucial to double-check that the formula’s numbers are all placed correctly. The equation is as follows, for instance, if the shareholders’ equity is $40,000 and the total debt is $10,000:
D/C ratio = $10,000 / ($10,000 + $40,000)
3. Calculate the D/C ratio
Once the numbers are in the formula, calculate the equation. Even though the formula appears straightforward, it may be helpful to perform the calculation twice to make sure you got the right answer. To double-check your work, think about using a calculator or asking a friend to complete the equation. When calculating financial data that could potentially change a company’s practices, accuracy is especially crucial.
4. Assess the result
The next step is to evaluate the results to determine if anything needs to change in the way the company operates after you’ve determined the D/C ratio. Think about whether a high ratio, for instance, has a significant impact on the organization. While having a lot of debt may have an impact on one company, it might not have the same effects on another. It’s best to consider a number of factors that go into the debt, such as the monthly loan payments and the company’s ability to pay off the debt quickly.
Example of how to use debt-to-capital ratio
Heres an example of a company calculating its D/C ratio:
Successful sales and marketing firm Premier Sales uses loans to fund its extensive marketing promotions and campaigns. Premier’s executives have been speaking with a prospective investor for the business. The CEO is asked to calculate the debt to capital ratio because the executives want the investor to understand the risk of investing in Premier Sales. The investor, however, decides they won’t invest unless the D/C ratio is lower than 40%.
The CFO gathers pertinent information and discovers that the company has $1 million in total equity, including common and preferred stock, and a total debt of $450,000. The CFO then enters this information into the D/C ratio formula:
Debt-to-capital = $450,000 / ($450,000 + $1,000,000)
Debt-to-capital = $450,000 / $1,450,000
Debt-to-capital = 0.3103 (or 31.03%)
The CFO reports the ratio to the other executives. They inform prospective investors that the D/C ratio is below their 40% cap. The company’s executives explain their relationship with debt and how it affects their financial operations using the ratio. The investor chooses to invest in Premier Sales because of the low ratio.
Debt-to-capital ratio vs. debt ratio
The D/C ratio is just one of many instruments used by financial experts to assess a company’s success. The debt ratio is another typical ratio that can be calculated using the following formula:
Debt ratio = total debt / total assets
Debt-to-capital only takes interest-bearing debt, such as loans, into account. In contrast, the debt ratio takes into account all forms of debt. These two formulas’ final ratios may be similar, but they measure various things. The debt ratio calculates how a company’s liabilities and assets are distributed, and the D/C ratio calculates how much financial risk the company faces.
FAQ
What is a good debt-to-capital ratio?
This ratio, which equals current assets divided by current liabilities, is used to assess how readily a business can make payments on its debts. A current ratio greater than two indicates that a company has more assets than liabilities.
Is a high debt-to-capital ratio good?
Key Takeaways: A company’s debt situation is shown by its debt-to-equity (D/E) ratio. Lenders and investors view a high D/E ratio as risky because it implies that the company is financing a sizable portion of its potential growth through borrowing.
Is it better to have a higher or lower debt-to-capital ratio?
Generally, a good debt-to-equity ratio is anything lower than 1. 0. A ratio of 2. 0 or higher is usually considered risky. When a company’s debt-to-equity ratio is negative, it means that it has more liabilities than assets, making it very risky.
Is a low debt-to-capital ratio good?
Generally speaking, a lower debt-to-equity ratio is preferred because it denotes less debt on a company’s balance sheet.
