Business managers often use ratios to determine the financial health of their firm. The net-debt-to-capital ratio helps managers assess whether their firm has an appropriate level of debt. When the ratio becomes too high or too low, it alerts business managers they need to rearrange the firm's sources of funds.
While gross debt includes all the debt a firm owes, net debt deducts the firm's cash, cash equivalents and short-term investments from the total debt owed. For example, if the firm owes a total of $1.25 billion and has a cash balance of $1 billion, its net debt is $250 million. Firms that carry a large cash balances often prefer to use net debt instead of gross debt.
You can find the amount of a firm's capital by adding the firm's net debt to shareholder's equity. You can also find it by deducting the firm's cash, cash equivalents and short-term investments from its total assets. You can use gross debt in calculating the firm's capital in other calculations, but you should consistently use net debt if you have already used it once in the same calculation.
To determine the net-debt-to-capital ratio, you divide the company's net debt by its capital. For example, if the company has a net debt of $69.7 million and shareholder's equity of $226.4 million, its capital amounts to $296.1 million and its net-debt-to-capital ratio is 23.5 percent. This means that the company uses debt to get 23.5 percent of its funds. Because the other source of funding is shareholder's equity, which can come from stocks or funds injected by the firm's owners, it also means that 76.5 percent of the firm's funds comes from its shareholders or owners.
Generally, the higher a firm's net-debt-to-capital ratio, the higher risk it faces. This is because carrying debt requires the firm to make regular payments. On the other hand, the company's owners or shareholders tend to be more flexible. As such, a firm with a high net-debt-to-capital ratio faces high pressure to create positive earnings. However, a lower ratio is not always better because various industries differ in the average debt that firms carry.