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Debt Equity Ratio MBA II

The document discusses various financial ratios used to analyze a company's financial position, including the debt-equity ratio, proprietary ratio, and capital gearing ratio. The debt-equity ratio compares a company's total debt to shareholders' equity to measure financial leverage. The proprietary ratio relates shareholders' equity to total assets to assess financial stability from creditors' perspective. The capital gearing ratio indicates the proportion of fixed-interest debt versus equity in a company's capital structure, and whether the company is "trading on equity" by earning returns higher than its overall profit rate.

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Niraj Gupta
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132 views17 pages

Debt Equity Ratio MBA II

The document discusses various financial ratios used to analyze a company's financial position, including the debt-equity ratio, proprietary ratio, and capital gearing ratio. The debt-equity ratio compares a company's total debt to shareholders' equity to measure financial leverage. The proprietary ratio relates shareholders' equity to total assets to assess financial stability from creditors' perspective. The capital gearing ratio indicates the proportion of fixed-interest debt versus equity in a company's capital structure, and whether the company is "trading on equity" by earning returns higher than its overall profit rate.

Uploaded by

Niraj Gupta
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© © All Rights Reserved
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DEBT EQUITY

RATIO
Debt Equity Ratio
 The debt-equity ratio is determined to
ascertain the soundness of the long-
term financial policies of the company.
It is also known as "External-Internal"
equity ratio.
 Debt-Equity Ratio =
External equities
Internal equities
Debt Equity Ratio
 The term external equities refers to
total outside liabilities and the term
internal equities refers to shareholders'
funds or the tangible net worth.
 If the ratio is 1 (i.e. outsiders' funds are
equal to shareholders' funds) it is
considered to be quite satisfactory.
Various form of Debt Equity Ratio
(i) Debt-Equity Ratio =
Total long-term debt
Total long-term funds
(ii) Debt-Equity Ratio =
Shareholders' funds
Total long-term funds
(iii) Debt-Equity Ratio =
Total long-term debt
Shareholders' funds
Debt Equity Ratio
 Ratio (i) and (ii) may be taken as ideal if they
are 0.5 each while the ratio (iii) may be taken
as ideal if it is 1.
 The investor may take debt-equity ratio as
quite satisfactory if shareholders' funds are
equal to borrowed funds. However, a lower
ratio, say 2/3rd borrowed funds and 1/3rd
owned funds, may also not be considered as
unsatisfactory if the business needs heavy
investment in fixed assets and has an assured
return on its investment
Significance of Debt Equity Ratio

The ratio indicate the proportion of


owners' stake in the business.
 Excessive liabilities tend to cause

insolvency. The ratio indicates the extent


to which the firm depends upon outsiders
for its existence.
 The ratio provides a margin of safety to

the creditors.
 It tells the owners the extent to which

they can gain the benefits or maintain


control with a limited investment.
Proprietary Ratio
 It establishes relationship between the
proprietor's funds and the total tangible assets.
 Proprietary Ratio =
Shareholder 's funds
Total tangible assets
 This ratio focuses the attention on the general
financial strength of the business enterprise.
 The ratio is of particular importance to the
creditors who can find out the proportion of
shareholders' funds in the total assets
employed in the business
Significance of Proprietary Ratio
 A high proprietary ratio will indicate a
relatively little danger to the creditors, etc., in
the event of forced re-organisation or winding
up of the company.
 A low proprietary ratio indicates greater risk to
the creditors since in the event of losses a part
of their money may be lost besides loss to the
proprietors of the business.
 The higher the ratio, the better it is. A ratio
below 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.
Capital Gearing Ratio
 Capital gearing (or leverage) refers to the
proportion between fixed interest or
dividend bearing funds and non-fixed
interest or dividend bearing funds in the
total capital employed in the business.
 The fixed interest or dividend-bearing
funds include the funds provided by the
debenture holder and preference
shareholders.
 Non-fixed interest or dividend bearing
funds are the funds provided by the
equity shareholders.
Capital Gearing Ratio

Funds bearing fixed interest or fixed dividends


Total capital employed

OR

Funds bearing fixed interest or fixed dividends


Equity Shareholders' Funds
Capital Gearing Ratio

 In case the amount of fixed interest or


fixed dividend-bearing funds is more than
the equity shareholders' funds, the
capital structure is said to be "high
geared".
 If the amount of equity shareholders'
funds is more than the fixed interest or
dividend bearing funds, the capital
structure is said to be "low geared".
 In case the two are equal, the capital
structure is said to be "even geared".
Significance of Capital Gearing Ratio
 The gearing ratio is useful in indicating the
extra residual benefits accruing to the equity
shareholders. Such a benefit accrues to the
equity shareholders because the company
earns a certain rate of return on total capital
employed but is required to pay to the
preference shareholders and debenture holders
only at a fixed rate.
 The surplus earned on their funds can be
utilised for paying dividend to the equity
shareholders at a rate higher than the rate of
return on the total capital employed in the
company. Such situation is called "Trading on
Equity".
Exercise: Capital Gearing Ratio
Equity Share Capital 1,50,000
Reserves 50,000
6% Debentures 2,00,000
7% Preference Share capital 1,00,000
The company earns a profit of Rs.1,00,000
before interest and tax. Calculate the
gearing ratio and test it for "Trading on
Equity". Tax rate may be taken at 50%.
Exercise: Capital Gearing Ratio
 The capital gearing ratio has been
calculated as follows :
Funds bearing fixed interest or fixed dividends
Total capital employed
6,00,000
10,00,000
= .6 or 60%

The capital structure is "high geared".


There should be "trading on equity".
Income Statement
Particulars Amt
Earning before interest & tax(EBIT) 100000
Less: Interest (I) 12000

Earning before tax (EBT) 88000


Less : Tax (t) 44000

Earning after tax (EAT) 44000


Less: Preference dividend (Pd) 7000

Earning for equity share (EES) 37000


Test of Trading on Equity
 Rate of Return on Equity Shareholders' Funds =
37,000
2,00,000
= 18.5%
 General Rate of Return =
56,000
5,00,000
= 11.2%
 The general rate of return is only 11.2% while
the return on equity shareholders' funds is
18.5%. Thus, there is trading on equity.
Significance of Capital Gearing
Ratio
 It is to be noted that the profits available to
equity shareholders of a company having a
high gearing ratio will be subject to wider
fluctuations as compared to a company which
has a low capital gearing ratio. This is because
in case of a company having a high capital
gearing ratio, a fixed amount of profit will go
to the persons who have provided fixed
interest or dividend bearing funds and the
balance left will be distributed among the
equity shareholders.

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