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The debt-to-capital ratio measures a company’s debt use when compared to total external financing. Companies often use external funds to help finance certain aspects of business operations. Debt and equity funds are the two most common types of eternal financing. Debt is typically less preferable as loans usually have fixed monthly payments a company must make in order to stay compliant with the lender. Dividing total debt by shareholder’s equity plus debt allows a company to determine it debt-to-capital ratio; lower figures indicate less debt use and lower risk.
Financial ratios are useful tools accountants and other stakeholders use to evaluate a company’s financial data. Ratios provide benchmarks for the company to compare its information to other businesses. This allows owners and managers to determine if their company is operating within normal standards or at a level that is outside of these marks. The debt-to-total capital ratio falls under the financial leverage ratio group, indicating the long-term solvency of a company. Individuals can calculate financial leverage ratios on a monthly basis when a business releases its financial statements.
A simple calculation will provide the debt-to-capital ratio. For example, a company lists $10,000 US Dollars (USD) on its balance sheet, along with $15,000 USD in stockholder’s equity. The form divides the $10,000 USD by $25,000 to determine the debt-to-capital ratio. The result is 0.60, or 60 percent. This indicates the company uses 60 percent of debt to finance operations through external funding; the number may change when a company obtains new financing.
Benchmarking is the primary use of the debt-to-capital ratio. While a company may have an internal procedure for limiting debt use, that does not really indicate how well the firm operates in the business environment. Owners and managers typically require only a certain percent of debt used for external financing. This comes from reviewing several different factors, such as cash flow, market conditions, and the industry standard. Factors may change as the business grows or contracts it operations.
In terms of having outside governance detailing calculation and use, financial ratios are not a standard accounting tool. Companies can create their own debt-to-capital formulas that best capture the use of debt in their operations. Stakeholders may desire this information released in financial or management disclosures, however. This information informs how a company manages its debt and plans to grow operations in the future. Stakeholders may question the assessment or use of debt from this information.
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