The capital structure of the company comprises both debt and equity. It is defined as the combination of debt and equity in the company, which is incorporated in the formation of the company. Both these components are used hand in hand in order to determine the number of liabilities that are owed by the company, and what needs to be done in order to ensure an optimal capital structure that minimizes the cost of capital for the firm.
From an investor’s perspective too, having insights regarding the capital structure is an important component, because it helps them to determine the gearing and the leverage of the company. Based on these decisions, they are subsequently able to make strategic decisions. Therefore, calculation of the weight of debt is considered to be a very important factor in this regard.
Weight of debt is simply defined as the percentage of debt of the total capital structure of the company. In other words, the weight of debt shows the ratio of debt that is taken on by the company. It is considered to be an important metric in the decision-making of the company because it draws a comparison between two broad sources of finance: equity and debt.
Weight of debt is calculated using the following formula:
Weight of Debt = Total Debt of the company / (Total Debt + Total Equity)
In the formula above, total debt is calculated by adding all the long-term debts of the company, whereas total equity is calculated by estimating the market capitalization of the company. Market Capitalization is calculated using the following formula:
Market Capitalization = Shares Issued by the company * Share Price
How to calculate the weight of Debt?
Weight of debt simply represents the percentage of the capital structure of the company that is financed using long-term liabilities. This is the amount that needs to be paid back by the company, so it is considered to be important to calculate the weight accurately so that subsequent calculations can be made properly.
In the case where the company has a weight of the debt of more than 50%, it is described as a high geared company. On the other hand, in the cases where the weight of debt is less than 50%, it is described as a low geared company. Being high geared might be perceived as high risk, but it comes with certain benefits including tax savings.
The extent to which the company raises and takes on more debt is supposed to be in line with the cost of capital. The main rationale in this regard is to achieve an optimal capital structure that optimizes their finance costs.
Calculation of weight of debt is illustrated in the following example:
Betty Inc. currently has 100,000 shares outstanding at $5 each. In the same manner, they have a long term debt of $250,000 on their books.
Using the scenario above, weight of debt is calculated as follows:
Weight of Debt = Total Debt Issued / (Total Debt + Total Equity)
Total Equity = Market Capitalization = 100,000 * $5 = $500,000
Total Debt = 250,000
Therefore, weight of debt = $250,000 / (250,000 + 500,000) = 33.3%
The weight above describes that the company has around 33.3% debt. The remaining 66.7% of the capital structure of Betty Inc. comprises of equity shares.
Implications of Weight of Debt
Weightage of debt is a really important metric that represents a couple of different things. This metric is important because it covers the following grounds:
- For the Stakeholders: For the external stakeholders (particularly creditors, financiers, and shareholders), this particular ratio is indicative of the level of risk involved within the company. In the case where this particular ratio is high, the company is generally perceived to be a high-risk company.
- For calculation of WACC (Weighted Average Cost of Capital); Weighted Average Cost of Capital (or WACC) is considered to be a crucial number for the company. It shows the cost that is incurred by the company in order to back the given resources. This calculation involves the weight of debt, and that is used by the company to make future strategic decisions.
- For the company: Organizations mainly decide on their capital structure depending on the personal preference of investors, and the Board of Directors. A lot of organizations prefer to be lowly-geared as compared to being highly geared. In this regard, it gets important for them to incorporate this particular metric in mind, to ensure that they stay beneath the prescribed threshold.