The solvency ratios will highlight the long term creditors about the ability of the firm to pay off its interest as soon as it matures for payments together with the principal as per terms and conditions so stipulated. The top eleven solvency ratios of a firm are discussed in this article.
This ratio measures the relationship between the shareholders’ fund and total asset of the firm (i.e. the ratio of proprietor’s fund to total assets).
It reveals the owners’ contribution to the total value of assets. Proprietor’s fund or Net Worth is equal to Equity Share Capital plus Preference Share Capital plus Reserves and Surplus plus Accumulated Funds minus balance of Profit and Loss Account minus Miscellaneous Expenditure.
No doubt it is an important indicator for measuring long-term solvency of a firm. There is no hard and fast norm about the standard ratio, yet 60% to 75% of the total assets should be financed by the proprietor’s fund. The higher the ratio, the lesser will be the reliance on outsiders, although too high a ratio may not be good for it. It would imply that external equities are not utilised properly.
Thus, the ratio is computed as:
Here, total assets represent the total resources of the firm.
Compute the Proprietary Ratio from the following:
Interpretation and Significance:
From the above illustration it becomes clear that 57% of the total assets has been financed out of Proprietor’s Fund (if Preference Share Capital is included) and the same is 43% (if Preference Share Capital is excluded). The solvency position can easily be tested with the help of this ratio. That is why either the analyst or the outsiders are interested in this ratio.
This ratio measures the claims of outsiders and the owners, i.e. shareholders against the assets of the firm. It is also known as External-Internal Equity Ratio. It actually measures the relationship between the external debts/equity/outsiders fund and Internal equities/shareholders fund.
In short, it expresses the relation between the external equities and internal equities, or the relationship between borrowed capital and owner’s capital. It is a measure of long-term solvency. It reveals the claims of creditors and shareholders against the assets of the firm, i.e. comparative proportion of Debts and Equity. Here, Debt and Creditors include all debts, whether long-term or short-term, or in the form of Mortagage, Bills and Debentures etc.
On the other hand, owner’s claims consist of Equity and Preference Share Capital + Reserves and Surplus + Capital Reserves + Reserves for Contingencies + Sinking Fund – Fictitious Assets viz. Preliminary Expenses etc.
There are some authorities who prefer to take Long-term Debts only instead of total debts. Again, some prefer to include preference share capital in external equities and not to include the same in shareholders’ fund. The reason for such opinion (i.e. inclusion of pref. share capital in external debts) is that they are entitled to a fixed rate of dividend and they are also redeemed after stipulated period.
In solving subsequent problems we have included preference shareholders.
Calculate the Debt-Equity Ratio from the following particulars for the year ended 31st Dec. 2005:
Interpretation and Significance:
This ratio tells the story about the utilisation of debt financing in a firm, i.e., proportion of claims between outsiders and the shareholders against assets of the firm, in order to give an information to the outsiders about their position while winding up. Assets are acquired by the utilisation of both outsiders’ fund and shareholders’ fund.
The shareholders desire to utilise more funds taken from the investors so that they will share lesser risk and, at the same time, to increase the rate of dividend after paying a smaller fixed rate of interest to outsiders.
Similarly, outsiders desire that shareholders should take the greater risk. Thus, the interpretation and significance of this ratio depends on the financial policy of the firm and nature and types of business. The norm of such ratio is 2: 1 although there is no standard norm which is applicable for all enterprises. Sometimes more than 2: 1 is found to be satisfactory.
A high ratio indicates that claims of outsiders are more than the owner and, naturally, they will demand to take part in management and creditors do not prefer such a situation, as in case of liquidation their margin of safety will be reduced. In short, the higher the ratio, the greater will be the risk to the creditors and this indicates too much dependence on long-term debts. On the contrary, a lower ratio reveals a high margin of safety to the creditors.
Capital gearing stands for the determination of proportion of various kinds of securities to the total capitalisation. The gearing may be high, low or even. When the proportion of Equity Share Capital is high in comparison with other securities in the total capitalisation, it is called low geared and in the opposite case, it is high geared.
At the same time if the equity share capital is equal to the other securities it is called evenly geared. Thus, capital gearing ratio is the ratio between Equity share capital and Fixed Interest Bearing Securities (i.e. debentures + Preference Shares + Long-term loans bearing fixed interest.
The following example will make the gearing principle clear:
From the above, it is quite clear that the Capital structure of Company X Ltd. is low geared, Company Y Ltd. is evenly geared, and company Z Ltd. is highly geared.
The higher the gear, the more speculative will be the character of equity shares since under the condition, dividend on equity shares fluctuates disproportionately with the amount of divisible profit.
Significance and interpretations:
It is needless to say that a highly geared Capital Gearing Ratio indicates greater dependence on debt capital. It also indicates that the firm bears a greater degree of financial risks as the debt capital must be redeemed at the stipulated period. The firm must have to pay fixed rate of interest on debt capital and fixed rate of dividend on preference shares.
Thus, a higher Capital Gearing Ratio is not desirable from the standpoint of solvency of .a firm. On the contrary, when the rate of return is higher than the average market rate of interest and pref. dividend, a higher Capital Gearing Ratio may be considered as a boom to the equity shareholders. Obviously, the rate of return to equity shareholders will increase. Similarly, in the opposite case i.e. when there is recession, if the rate of return is found to be very low a highly geared Capital Gearing Ratio is dangerous.
This ratio reveals the relationship between the long-term funds raised from the outsiders and the total capitalisation (i.e. long-term funds) of a firm. Funded debts include Debentures plus Mortgage Loan + Bonus and other long-term loans. Similarly, total capitalisation includes Equity Share Capital plus Pref. Share Capital plus Reserve and Surplus + Undistributed Profit plus Debentures, Mortgage Loan, Bonus and other long-term loans.
Thus, the ratio is:
In short, this ratio highlights that part of total capitalisation which has been financed by the outsiders. 50-55% is considered as normal.
This ratio explains the relationship between the total liabilities to outsiders and the total assets of a firm.
It is calculated as:
If the ratio is found high, it will indicate that the long-term solvency position is not stable or unsatisfactory, and vice versa in the opposite case.
This ratio explains the relationship between the fixed assets (after depreciation) and the total long-term funds. Total long-term funds include shareholders.’ fund plus long-term borrowings.
It is expressed in term of percentage:
This ratio reveals how much amount of fixed assets are financed by long-term funds. Usually, total investment in fixed assets must be equal to total long-term funds, i.e. ratio should be 1: 1. If it is found that total investment in fixed assets is more than the total long- term funds, it means that excess has been financed from current funds, which is not at all desirable from the standpoint of long-term solvency position of a firm and, in the opposite case, a part current funds or Working Capital has been financed from long-term funds.
(a) Total Fixed Assets to Proprietor’s Equity /Assets-Proprietorship Ratio:
It reveals how much of Proprietor’s Fund is being invested in fixed assets. If the major part is invested in fixed assets, Working Capital may be inadequate.
Normally, 60% to 75% should be invested in fixed assets:
(b) Total Current Assets to Proprietor’s Equity:
It indicates how much of Proprietor’s Fund is being invested in current assets.
If the investment is found to be too small, working capital may be inadequate:
(c) Total Current Assets to Proprietor s Equity Ratio = Total Current Assets / Proprietor’s Equity
This ratio measures the relationship between the Net Profit (before Interest and Tax) and the Fixed Interest charges. It is also known as Coverage Ratio or Fixed Charge Cover Ratio. Thus
This ratio indicates the abilities of the firm to generate cash for the repayment of debt. Cash flow technique is recommended as earnings are affected by accruals and deferrals to generate Cash.
It is calculated as:
From the following Balance Sheet of Amrita Ltd. calculate the following ratios:
(a) Funded Debts to Total Capitalisation Ratio;
(b) Total Liabilities to Total Assets Ratio;
(c) Fixed Assets Ratio;
(d) Total Fixed Assets to Proprietor’s Equity/Fixed Assets-Proprietorship/Ratio
(e) Total Current Assets to Proprietor’s Equity Ratio/Current Assets Proprietorship Ratio
(f) Interest Coverage Ratio.
This ratio is the modified version of Interest Coverage Ratio and is calculated as under.
It is also known as Debt Cash Flow Coverage Ratio:
The ratio is important in the sense that interest is paid out of cash inflow and not out of profit. Moreover, Sinking Fund appropriation on debts must also be taken into consideration in order to find out Debt Cash Flow Coverage as a test of long-term solvency position. Higher the coverage, better will be the long-term solvency, and vice versa in the opposite case.
Compute cash to Debt Service Ratio from:
Net Profit (after Tax) Rs. 25,000; Depreciation Rs. 5,000; Fixed Interest Charges Rs. 5,000; Rate of Tax @ 50% Sinking Fund Appropriation 10% of Outstanding Debentures, 10% Debentures Rs. 50,000.
(i) Ratio of Assets Cover of Debentures.
(ii) Ratio of Assets Cover of Ordinary Creditors.
(iii) Ratio of Assets Cover of Preference Shareholders.
(iv) Ratio of Assets Cover of Equity Share Capital.
(v) Security Cover.
Assets cover reveals how much of the assets is covered by the respective claimants. As for example, Assets cover of Preference Shareholders means: Assets (less securities for Secured Creditors, if any) available for Preference Shareholders by the number of Preference Shares which, ultimately, indicates the Assets available for each rupee of Preference Share. Same principle is being applied in other cases also.
But security cover means value of securities cover for secured loans: