Strategies Used To Reduce a Company’s Debt-to-Capital Ratio
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The debt-to-capital ratio is a financial leverage ratio, similar to the debt-to-equity (D/E) ratio. It compares a company’s total debt to its total capital, which is composed of debt financing and equity. The ratio is used as a baseline for a company’s financial standing and is something investors use when determining the risk of a particular investment.
Key Takeaways
- The debt-to-capital ratio is a financial leverage ratio, similar to the debt-to-equity ratio.
- This metric indicates a company’s overall financial soundness while revealing the proportionate levels of debt and equity financing.
- Increasing profitability, better management of inventory, and restructuring debt can help lower a company’s debt-to-capital ratio.
Why Companies Use the Debt-to-Capital Ratio
The debt-to-capital ratio indicates a company’s overall financial soundness. It also reveals the proportionate levels of debt and equity financing. A value of 0.5 or less is considered good, while a value greater than 1 indicates that a company is technically insolvent.
This ratio is also used to determine the extent to which a company can invest based on the size of its available assets. For example, a company with a high debt-to-capital ratio assumes a big risk if it leverages existing equipment or real estate as collateral for a new venture. Since they would theoretically increase their ratio, they would be seen as a greater liability as the leveraged items might not be enough to cover their financial obligations if the new venture didn’t go as planned.
Companies can take steps to reduce and improve their debt-to-capital ratios. These strategies include increasing profitability, better management of inventory, and restructuring debt. Whatever the method(s), it’s best used in tandem with each other. It can also be used in conjunction with a rise in the pricing of their goods or services if the timing is right.
Always make sure you compare the financial ratios of similar companies within the same industry. This will give you an apples-to-apples comparison so you can make better, more informed decisions about your investments.
Increased Revenue
The most logical step a company can take to reduce its debt-to-capital ratio is by increasing sales revenues and hopefully profits.
This can be achieved by raising prices, increasing sales, or reducing costs. In certain cases, companies may also accomplish this by entering new markets and adding new products and services. Streamlining operations can also have a big impact on a company’s revenue stream.
Regardless of the plans, any extra cash generated can be used to pay off existing debt.
Inventory Management
Another measure that can be taken to reduce the debt-to-capital ratio is more effective inventory management. Inventory can take up a very sizable amount of a company’s working capital. Maintaining unnecessarily high levels of inventory beyond what is required to fill customer orders in a timely fashion is a waste of cash flow.
Companies can examine the days sales of inventory (DSI) ratio, part of the cash conversion cycle (CCC), to determine how efficiently inventory is being managed.
Debt Restructuring
Restructuring debt provides another way to reduce the debt-to-capital ratio. If a company pays relatively high interest rates on its loans, and current interest rates are significantly lower, the company can seek to refinance its existing debt.
This will reduce interest expenses and monthly payments, which improves the company’s bottom-line profitability and its cash flow while increasing its stores of capital. This is a common and straightforward method used to broker better terms for the company and its outflows.
What’s the Formula for Debt-to-Capital?
Debt-to-capital is a financial ratio that determines how much debt a company has compared to its capital. You can easily calculate this ratio by using the following formula;
Debt-to-Capital Ratio = Total Debt ÷ (Total Debt + Total Shareholders’ Equity)
How Does a Company’s Inventory Affect its Debt-to-Capital Ratio?
High inventory can have a direct impact on a company’s working capital. That’s because companies have to spend money to store their inventory—especially when that inventory is sitting around and isn’t moved from the shelf to consumers. Excess inventory may require borrowing, thereby raising the amount of debt on the books. Efficient inventory management enables companies to free up capital and cut back on the amount of debt they may need to borrow.
Where Can I Find a Company’s Debt and Shareholders’ Equity?
You can easily find a company’s total debt and shareholders’ equity on its balance sheet. Debt is located under the liabilities section. Having this information can help you determine its debt-to-capital ratio by dividing total debt by the sum of the total debt and shareholders’ equity.
The Bottom Line
Companies can use certain tools like debt restructuring and inventory management in order to lower their debt-to-capital ratio. By using certain bottom-line accounting techniques, the company can help to make themselves appear in a better financial position without the fear of insolvency.
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