Solvency Ratios: Debt-Equity Ratio
Solvency Ratios: Debt-Equity Ratio
Solvency Ratios: Debt-Equity Ratio
The persons who have advanced money to the business on long-term basis
areinterested in safety of their periodic payment of interest as well as the
repaymentof principal amount at the end of the loan period. Solvency ratios are
calculatedto determine the ability of the business to service its debt in the long run.
Thefollowing ratios are normally computed for evaluating solvency of the business.
1. Debt-Equity Ratio;
2. Debt to Capital Employed Ratio;
3. Proprietary Ratio;
4. Total Assets to Debt Ratio;
5. Interest Coverage Ratio.
Debt-Equity Ratio
Debt-Equity Ratio measures the relationship between long-term debt and equity.If
debt component of the total long-term funds employed is small, outsiders feelmore
secure. From security point of view, capital structure with less debt andmore equity is
considered favourable as it reduces the chances of bankruptcy.Normally, it is
considered to be safe if debt equity ratio is 2 : 1. However, it mayvary from industry
to industry. It is computed as follows:
Debt-Equity Ratio =Long − term Debts / Shareholders' Funds
where:
Shareholders’ Funds (Equity) = Share capital + Reserves and Surplus +Money
received against share warrants
Share Capital = Equity share capital + Preference share capital
or
Shareholders’ Funds (Equity) = Non-current assets + Working capital –Non-current
liabilities
Working Capital = Current Assets – Current Liabilities
It may be noted that Debt to Capital Employed Ratio can also be computedin relation
to total assets. In that case, it usually refers to the ratio of total debts(long-term debts
+ current liabilities) to total assets, i.e., total of non-currentand current assets (or
shareholders, funds + long-term debts + current liabilities),and is expressed as
Debt to Capital Employed Ratio = Total debts/ Total Assets
Proprietary Ratio
Proprietary ratio expresses relationship of proprietor’s (shareholders) funds tonet
assets and is calculated as follows :
Proprietary Ratio = Shareholders, Funds/Capital employed (or net assets)
The higher ratio indicates that assets have been mainly financed by owners funds
and the long-term loans is adequately covered by assets. It is better to take the net
assets (capital employed) instead of total assets forcomputing this ratio also. It is
observed that in that case, the ratio is the reciprocalof the debt to capital employed
ratio.
Significance: This ratio primarily indicates the rate of external funds in financingthe
assets and the extent of coverage of their debts are covered by assets.
Significance: The liquidity position of the firm depends upon the speed withwhich
trade receivables are realised. This ratio indicates the number of timesthe
receivables are turned over and converted into cash in an accounting period.Higher
turnover means speedy collection from trade receivable. This ratio alsohelps in
working out the average collection period. The ratio is calculated bydividing the days
or months in a year by trade receivables turnover ratio.
Significance : It reveals average payment period. Lower ratio means credit allowedby
the supplier is for a long period or it may reflect delayed payment to supplierswhich
is not a very good policy as it may affect the reputation of the business.The average
period of payment can be worked out by days/months in a year bythe Trade Payable
Turnover Ratio.
Significance : High turnover of capital employed, working capital and fixed assetsis a
good sign and implies efficient utilisation of resources. Utilisation of capitalemployed
or, for that matter, any of its components is revealed by the turnoverratios. Higher
turnover reflects efficient utilisation resulting in higher liquidityand profitability in the
business.