Getting to Know the Debt-to-Capital Ratio

Evaluating your small business's financial health can be a breeze with the right tools. One useful option is the debt-to-capital ratio (D/C ratio), which shows how much debt your business has compared to its total capital. It's an essential metric because it can uncover financial issues you might not even be aware of. Imagine hitting those sales targets and raking in profits but still drowning in debt—it's a recipe for future troubles.

Grasping the debt-to-capital ratio is crucial for making smart financial and investment decisions. It's also handy if you’re eyeing a company to acquire or invest in. Our SLIM Capital blog post will guide you through calculating this key metric and offer tips to use it effectively, plus advice on improving your D/C ratio.

What’s the Debt-to-Capital Ratio?

In short, the debt-to-capital ratio measures a company's leverage by comparing its total obligations to its capital. This ratio gives business owners a snapshot of their financial situation, helping them make necessary investment, budgetary, or operational adjustments.

For instance, if a business has a high debt-to-capital ratio, it's heavily reliant on debt to operate, risking liquidity issues or bankruptcy. The business owner would need to find ways to manage debts better and lower that ratio.

How to Calculate the Debt-to-Capital Ratio

Good news—calculating your debt-to-capital ratio is straightforward if your financial records are accurate. Just divide your total debt by the sum of your debt and shareholder equity. Debt includes short- and long-term liabilities, while shareholder equity covers the entire company equity (common and preferred stock, minority interest).

Example time! A manufacturing company with $1.25 million in debt and $5.75 million in shareholder equity would calculate it like this:

• $1.25 million / ($1.25 million + $5.75 million) = 0.178 or 17.8%

This result means 17.8% of its operations are funded by debt—a low and favorable ratio, indicating high income coverage and future investment opportunities with minimal equity financing.

Low vs. High Ratios

Aim to keep a low debt-to-capital ratio. Benefits include better access to financing with favorable terms, efficient capital use, and improved creditworthiness. On the flip side, a high ratio means your company relies heavily on borrowed money, increasing risks like high interest costs and reduced liquidity.

Wondering what counts as low or high? In our earlier example, 17.8% is great. But if it hits 50% or more, that's a red flag indicating more debt than equity—unhealthy for the business.

Improving Your Ratio

In a perfect world, you'd have consistent sales and profits, with some set aside to pay off debt. Realistically, though, that might not always happen. Here’s how to improve your ratio:

• Cut down debt. If you have a high-interest loan, ask your lender about refinancing. Consider consolidating multiple loans into one to lower payments and interest.

• Unload unsold inventory. Excess inventory ties up cash, increases debt, and hogs storage space. Running a sale might be the way to go.

Wrapping Up

A solid debt-to-capital ratio is key for financial health and stability. It measures how much debt your company holds against its assets. By improving this ratio, you reduce leverage and ensure enough cash flow and working capital to cover liabilities.