The debt-to-capital ratio is a financial leverage ratio, similar to the debt-to-equity (D/E) ratio, that compares a company's total debt to its total capital, which is composed of debt financing and equity. The ratio is something used as a baseline for a company's financial standing and is something investors use when determining the risk of a particular investment.
What the Ratio Is Used for
This metric provides an indication of a company's overall financial soundness, as well as revealing the proportionate levels of debt and equity financing. A value of 0.5 or less is considered good, while any value greater than 1 shows a company as being technically insolvent.
The ratio is also used to determine the extent a company can invest based on the size of their available assets. For example, a company with a high debt-to-capital ratio would be taking a big risk if they leveraged existing equipment or real estate as collateral for a new venture. Since they would theoretically be increasing their ratio, they would be seen as a greater liability since the leveraged items might not be enough to cover their financial obligations if the new venture did not work out as planned.
How Companies Mitigate Risk
Companies can take steps to reduce and improve their debt-to-capital ratios. Among the strategies that can be employed are increasing profitability, better management of inventory, and restructuring debt. The methods used to lower the ratio are best used in tandem with each other and, if the market timing is right, used in conjunction with a rise in the pricing of their goods or services.
The most logical step a company can take to reduce its debt-to-capital ratio is that of increasing sales revenues and hopefully profits. This can be achieved by raising prices, increasing sales, or reducing costs. The extra cash generated can then be used to pay off existing debt.
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 day's sales of inventory (DSI) ratio, part of the cash conversion cycle (CCC), to determine how efficiently inventory is being managed.
Restructuring debt provides another way to reduce the debt-to-capital ratio. If a company is largely paying 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 both interest expenses and monthly payments, improving the company's bottom-line profitability and its cash flow and increasing its stores of capital. This is a common and straightforward method used to broker better terms for the company and their outflows.
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.