Study Material & Notes for the Chapter 11
COMPANY - ACCOUNTING RATIOS
III. SOLVENCY RATIOS
A. Meaning
- The term ‘solvency’ refers to the ability of a concern to meet its long term obligations.
- The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and public who made deposits
- The Solvency ratios indicate firm’s ability to meet Its interest payments and repayment schedules associated with its long term borrowings.
B. Type
1. Debt Equity Ratio
2. Total Assets to Debt Ratio
3. Proprietary Ratio
4. Interest Coverage Ratio
C. Debt Equity Ratio
a. Meaning
- It is calculated to know the relative claims of outsiders and the owners against the firm’s assets.
- This ratio establishes the relationship between the outsiders funds and the shareholders funds
b. Formula
- It is computed by dividing Long-term debts by Shareholders Funds
- Debt Equity Ratio = Long-term DebtsShareholders Funds
- Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions
- Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves & Surplus – Fictitious Assets
or
- Shareholders Funds = Non Current Assets (i.e. Tangible & Intangible assets, Non-current Investments + Long-term Loans & Advances) + Working Capital (i.e. Current Assets – Current Liabilities) Non-current Liabilities (i.e. Long-term Borrowings + Long-term Provisions)
c. Important Considerations
- The Debt Equity ratio is expressed pure i.e. 1:1
- The ideal range for the Debt Equity ratio is 2
- A lower Debt Equity ratio is preferred as it indicates less debt on a company’s balance sheet.
- The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the Organization by the Owners.
- This ratio is very useful to assess the soundness of long term financial position of the firm.
- It also indicates the extent to which the firm depends upon outsiders for its existence.
- A low debt equity ratio implies the use of more equity than debt.
D. Total Assets to Debt Ratio
a. Meaning
- Total Assets to Debt ratio measures the extent of the coverage of long-term debts by assets.
- This ratio measures safety margin available to lenders of long term debt
b. Formula
- It is computed by dividing Total Assets by Debt
- Total Assets to Debt Ratio = Total Assets/(Debt i.e Long-term Loans)
- Total Assets = Non-current assets + Current Assets
- Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions + Long-term liabilities
- Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
- Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)
c. Important Considerations
- The Total Assets to Debt ratio is expressed pure i.e. 2:1
- This ratio measures the safety margin available to lenders of long-term debts. It measures the extent to which debt is being covered by assets
- A higher total assets to debt ratio is generally seen as a healthy sign of financial health, indicating that a company has sufficient assets to cover its debts.
- A lower ratio suggests a higher level of financial risk, as it indicates that a significant portion of assets is financed by debt.
- A declining ratio may indicate that a company is taking on more debt relative to its assets, which can be a warning sign.
E. Proprietary Ratio
a. Meaning
- Proprietary ratio establishes the relationship between Shareholders’ funds to Total assets of the firm
- Proprietary ratio throws light on the general financial position of the enterprise. Proprietary Ratio shows the extent to which total assets have been financed by proprietor
b. Formula
- It is computed by dividing Shareholder Funds by Total Assets
- Proprietary Ratio = Shareholders or Proprietary Funds/Total Assets
- Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves and Surplus
- Total Assets = Non Current Assets + Current Assets
- Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
- Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)
c. Important Considerations
- The Proprietary ratio is expressed in fraction
- The ideal range for Proprietary ratio is 0.5
- A ratio below 0.50 may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses
- A high ratio shows that there is safety for creditors of all types hence a higher ratio is better for the Organization
- This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets employed in the firm.
- Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors
F. Interest Coverage Ratio
a. Meaning
- It is a ratio which deals with the servicing of interest on loan.
- It is a measure of security of interest payable on long-term debts
- It expresses the relationship between profits available for payment of interest and the amount of interest payable.
- It is also known as debt service ratio or fixed charges coverage ratio
- Interest Coverage Ratio is computed to measure the debt servicing capacity of a firm so far as fixed interest on long-term debt is concerned.
b. Formula
- It is computed by dividing Net Profit before by Interest on Long-term debts
- Interest Coverage Ratio = (Net Profit before Interest and Tax) / (Interest on Long-term debts)
- Net Profit before Interest and Tax = Profit after Tax + Tax + Interest on long-term debts
- Interest on long-term debts = interest on debentures, loans long-term debts or borrowings.
c. Important Considerations
- The Interest coverage ratio is expressed in times
- The ideal interest coverage ratio is 6 to 7 times
- This ratio shows how many times the interest charges are covered by the profits available to pay interest
- Higher the ratio, more secure the lender is in respect of payment of interest regularly.
- A higher ratio indicates that the Organization can meet its interest burden regularly.