# Accounting Ratios Notes2

## COMPANY - ACCOUNTING RATIOS

#### II.  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 other creditors selling goods on credit
• The Solvency ratios indicate firm’s ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings.
##### 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 or 2:5
• 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
• 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
• The ideal range for the Total Assets to Debt ratio is between 0.3 to 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better
• The ideal range for the Total Assets to Debt ratio is between 0.3 to 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better
• Total Assets to debt ratio of 0.6 or higher makes it more difficult to borrow money.
##### 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)

###### 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 even if its earnings before interest and taxes is low and vice-versa.
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