SOLVENCY RATIO

Solvency Ratios

1.   Debt equity ratio:

Debt-Equity ratio  = Long-term Debt’s

                             Shareholders Fund

Where Shareholders Funds =   Equity Share Capital + Reserves and Surplus (equity)– Fictitious Assets + Preference Share Capital. Alternatively, it can be calculated as Non–fictitions Total Assets – Total External Liabilities.

Long-term Funds = Debentures + Long-term Loans

Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to the long-term lender regarding extent of security of the debt. As indicated earlier, a low debt equity ratio reflects more security. A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting its obligations to outsiders. However, from the perspective of the owners, greater use of debt trading on equity may help in ensuring higher returns for them if the rate of earnings on capital employed is higher than the rate of interest payable. But it is considered risky and so, with the exception of a few business, the prescribed ratio is limited to 2:1. This, ratio is also termed as ‘Leverage Ratio’

2.   Debt Ratio

Debt Raio = Long-term Debt/Capital Employed (or Net Assets)

Capital employed is equal to the long-term debt + shareholders’ fund. Alternatively, it may be taken as net assets which are equal to the total nonfictitionies assets – current liabilities

Significance : Like debt equity ratio, it shows proportion of long-term debt in capital employed. Low ratio provides security to creditors and high ratio helps management in trading on equity. In the above case, the debt ratio is less than half which indicates reasonable funding by debt and adequate security of debt.

3.   Proprietary Ratio

Proprietary Ratio = Shareholders Funds/Capital employed (or net assets)

Significance: Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors. This ratio can also be computed in relation to total assets in lead of net assets (capital employed).

4.   Total Assets to Debt Ratio

Total assets to Debt Ratio  =  Total assets/Long-term debt

Significance. This ratio primarily indicators the rate of external funds in financing the assets and the extent of coverage of their debt is covered by assets.

5.   Interest Coverage Ratio

Interest Coverage Ratio = Net Profit before Interest and Tax / Interest on long term debt

Significance: It reveals the number of times interest on long-term debt is covered by the profits available for interest. A higher ratio ensures safety of interest payment debt and it also indicates availability of surplus for shareholders.