The capital to debt ratio is a measure of indebtedness – it’s the solvency of a company. This ratio shows a growing trend where the share of debt capital has increased. However, this indicator of indebtedness is not quite adequate because it does not say anything about the structure of debt, what is the share of short-term and how much is long-term debt.
There is no general measure of what the ratio of other people’s and own capital should be, so the ratio needs to be compared with the average branch ratio. Numerous factors can affect its size, such as:
- Whether the company has mainly tangible or intellectual assets;
- What the investment opportunities in projects are;
- How the profitability of projects is estimated;
- What the degree of required financial leverage is, etc.
What Is a Debt to Capital Ratio Calculator?
The debt to capital calculator is amazing integrated software that helps you calculate the debt to capital ratio, as its name suggests. What you need to do is to just type in the info it asks for, and press a single button. That’s it! You will have the results in a second.
Formula: How to Calculate It?
Debt-to-capital ratio = interest-bearing debt / (Interest-bearing debt + shareholders’ equity)
To help you understand it better, we have prepared a simple but good example for you. Take a look below!
| InterestBearingDebt | $1,000 |
| Shareholder’s Equity | $2,000 |
After reading the data stated in the table, use it in the formula above to calculate the debt to capital ratio.Debt-to-capital ratio = 1,000 / (1,000 + 2,000)Debt-to-capital ratio = 1,000 / 3,000Debt-to-capital ratio = 33.33%
What Is Financial Leverage?
Financial leverage is one of the many ways to increase profits, which involves a combination of own and borrowed funds when investing in something. The term “leverage” is borrowed from physics. It means that a person can lift a heavier load if he uses a lever and a support point. The weight of the load that a person can lift increases with the length of the lever. In finance, the company uses its own funds as support that’s borrowed as leverage to lift a higher burden. That can help it to make a higher profit.
The leverage is imposed as the basic tool for buying higher value on the stock exchange with smaller amounts of money. With the support of an appropriate broker, it is possible to buy higher-value assets with less money without risking more than the amount invested.
For example, if a company invests $400,000 in an investment to buy land, and it comes from a 25 percent increase in the price of that land, then it will have a return on invested money or a rate of 25 percent. However, if we assume that the company decides to use $100,000 of its own funds and borrow €300,000 from the bank. Then it will invest $400,000 in the purchase of land. In this case, the difference is that the company sells the land at a 25 percent higher price. Now it has a return on invested money of as high as 91 percent.
You may wonder how. We will take another example. Let’s say the company invested $100,000. After paying interest on the invested funds that is equal to $10,000, the company realizes as much as 91 percent of the return on invested money (100,000 / 100,000 + 10,000). It should be noted that if the company invests only $100,000 out of $400,000 of its funds, it’s going to pay the current costs with the remaining $300,000. Thus, it will eventually have more cash available for other activities.
The intensity of the use of financial leverage can be determined by 2 most important indicators:
- Degree of indebtedness (how much of the company’s total assets are financed from other people’s sources; it represents the risk of returning funds to creditors), and
- The debt-to-equity ratio (the company should not borrow above equity values).
Types of Financial Leverage
Positive leverage (favorable leverage)
The company uses the funds it received at a fixed cost (debt with interest or preferred stock at a dividend rate) in order to earn more than the fixed financing costs were paid. It is realized due to the degressive nature of fixed financing costs. An increase in debt when it comes to sources of financing, which is interest the company pays the debt, generates positive effects of financial leverage. That’s because unit fixed financing costs decrease with the increasing financial results.
Negative leverage (unfavorable leverage)
Negative leverage occurs when the company does not earn as much as its fixed financing costs. It is realized due to the increase of market interest rates so that the company pays off the debt. An increase in debt results in the negative effects of financial leverage. They are generated through debt and increase total operating costs, which reduce its value as a whole.
Why Is Financial Leverage Important?
Owners and managers must be aware of the level of financial leverage and its impact on the company’s operations, and they also must be ready to respond to future revenue growth/decline. Leverage risk arises when a fund uses debt or derivative leverage to increase potential gains. This may translate into an increase in losses.
If you have highly indebted companies with high financial leverage, it is crucial to arrange financial obligations as long as possible. You also need to tie their maturities to the main inflows while leaving some cash and a certain part of the assets without collateral that can be sold relatively freely and quickly. In case the borrowed capital is higher and if the required fixed expenses are high as well, there is a higher risk that the company will not be able to cover these fixed financing expenses through its regular operations.
This can only be achieved by financing from own sources. If the company finances its business with its financial resources (own capital and/or share capital), there is no effect of financial leverage either. The interest of the company is that the factor of financial leverage is as low as possible. It shows how quickly and how frequently the gross financial result changes when the business result changes by one percent.