Solvency Ratios: Debt-Equity Ratio

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Solvency Ratios

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

Significance: This ratio measures the degree of indebtedness of an enterpriseand


gives an idea to the long-term lender regarding extent of security of thedebt . As
indicated earlier, a low debt equity ratio reflects more security. A highratio, on the
other hand, is considered risky as it may put the firm into difficultyin meeting its
obligations to outsiders. However, from the perspective of theowners, greater use of
debt (trading on equity) may help in ensuring higherreturns for them if the rate of
earnings on capital employed is higher than therate of interest payable.

Debt to Capital Employed Ratio


The Debt to capital employed ratio refers to the ratio of long-term debt to thetotal of
external and internal funds (capital employed or net assets). It is computedas
follows:
Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)
Capital employed is equal to the long-term debt + shareholders’ funds.
Alternatively, it may be taken as net assets which are equal to the total assets –
current liabilities
Significance: Like debt-equity ratio, it shows proportion of long-term debts incapital
employed. Low ratio provides security to lenders and high ratio helpsmanagement in
trading on equity. In the above case, the debt to Capital Employedratio is less than
half which indicates reasonable funding by debt and adequatesecurity of debt.

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)

Significance: Higher proportion of shareholders funds in financing the assets isa


positive feature as it provides security to creditors. This ratio can also becomputed in
relation to total assets instead of net assets (capital employed). Itmay be noted that
the total of debt to capital employed ratio and proprietoryratio is equal to 1.

Total Assets to Debt Ratio


This ratio measures the extent of the coverage of long-term debts by assets. It is
calculated as:
Total assets to Debt Ratio = Total assets/Long-term debts

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.

Interest Coverage Ratio


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
calculated as follows:
Interest Coverage Ratio = Net Profit before Interest and Tax/ Interest on long-term
debts

Significance: It reveals the number of times interest on long-term debts is coveredby


the profits available for interest. A higher ratio ensures safety of interest ondebts.

Activity (or Turnover) Ratio


These ratios indicate the speed at which, activities of the business are being
performed. The activity ratios express the number of times assets employed, or, for
that matter, any constituent of assets, is turned into sales during an accounting
period. Higher turnover ratio means better utilisation of assets and signifiesimproved
efficiency and profitability, and as such are known as efficiency ratios.The important
activity ratios calculated under this category are
1. Inventory Turnover;
2. Trade receivable Turnover;
3. Trade payable Turnover;
Inventory Turnover Ratio
It determines the number of times inventory is converted into revenue
fromoperations during the accounting period under consideration. It expresses
therelationship between the cost of revenue from operations and average
inventory.The formula for its calculation is as follows:
Inventory Turnover Ratio = Cost of Revenue from Operations / Average Inventory

Where average inventory refers to arithmetic average of opening and


closinginventory, and the cost of revenue from operations means revenue from
operationsless gross profit.

Significance : It studies the frequency of conversion of inventory of finishedgoods


into revenue from operations. It is also a measure of liquidity. It determineshow many
times inventory is purchased or replaced during a year. Low turnoverof inventory
may be due to bad buying, obsolete inventory, etc., and is a dangersignal. High
turnover is good but it must be carefully interpreted as it may bedue to buying in
small lots or selling quickly at low margin to realise cash.Thus, it throws light on
utilisation of inventory of goods.

Trade Receivables Turnover Ratio


It expresses the relationship between credit revenue from operations and
tradereceivable. It is calculated as follows :
Trade Receivable Turnover ratio = Net Credit Revenue from
Operations/AverageTrade Receivable
Where Average Trade Receivable = (Opening Debtors and Bills Receivable +
Closing
Debtors and Bills Receivable)/2

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.

Number of days or Months/Trade receivables turnover ratio

Trade Payable Turnover Ratio


Trade payables turnover ratio indicates the pattern of payment of trade payable.As
trade payable arise on account of credit purchases, it expresses relationshipbetween
credit purchases and trade payable. It is calculated as follows:
Trade Payables Turnover ratio = Net Credit purchases/Average trade payable
Where Average Trade Payable = (Opening Creditors and Bills Payable +Closing
Creditors and Bills Payable)/2
Average Payment Period =No. of days/month in a year/Trade Payables 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.

Net Assets or Capital Employed Turnover Ratio


It reflects relationship between revenue from operations and net assets
(capitalemployed) in the business. Higher turnover means better activity and
profitability.It is calculated as follows :
Net Assets or Capital Employed Turnover ratio =Revenue from Operation/Capital
Employed

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.

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