The ratios are broadly classified under categories as follows :
• Solvency ratios
• Liquidity ratios
• Activity ratios
• Profitability ratios
• Market test ratios
Long-term Solvency Ratios
These ratios are primarily calculated to predict the ability of the firm to meet all its liabilities including those not currently payable. A set of ratios will give us information on the ability of the firm to meet its entire financial obligation in future. Before proceeding further, let us make a distinction between long term and short tem financial liabilities. Long-term financial liabilities are those financial liabilities that are to be met in the subsequent financial years whereas short-term liabilities are to be met in the current financial year itself. The ratios that are used to measure solvency are as follows :
• Debt Equity Ratio
• Shareholders Equity Ratio
• Debt to Net Worth Ratio
• Capital Gearing Ratio
• Fixed Asset to Long-Term Funds Ratio
• Proprietary Ratio
• Dividend Cover
• Interest Cover
• Debt Service Coverage Ratio
• Solvency ratios
• Liquidity ratios
• Activity ratios
• Profitability ratios
• Market test ratios
Long-term Solvency Ratios
These ratios are primarily calculated to predict the ability of the firm to meet all its liabilities including those not currently payable. A set of ratios will give us information on the ability of the firm to meet its entire financial obligation in future. Before proceeding further, let us make a distinction between long term and short tem financial liabilities. Long-term financial liabilities are those financial liabilities that are to be met in the subsequent financial years whereas short-term liabilities are to be met in the current financial year itself. The ratios that are used to measure solvency are as follows :
• Debt Equity Ratio
• Shareholders Equity Ratio
• Debt to Net Worth Ratio
• Capital Gearing Ratio
• Fixed Asset to Long-Term Funds Ratio
• Proprietary Ratio
• Dividend Cover
• Interest Cover
• Debt Service Coverage Ratio
(a) Debt Equity Ratio: There are two sources of capital − equity and debt.
Debts are raised when owners want to increase investment but are unwilling to dilute the equity or the cost of debt is less than that of equity.There are many ways to calculate this ratio but the most commonly used method is :
Debt equity ratio = Long term debt/ Share holder funds
In other method instead of long term, debts all the debts are taken into consideration. This ratio indicates the relationships between loan funds and net worth of the company that is known as gearing. It also depicts the relative contribution of owners and creditors. A company with a high component of debt capital relative to its equity is known as a highly geared company and vice-versa. There is no standard debt equity ratio and the same will vary from industry to industry. For capital-intensive industries and industries, having a high gestation period this ratio will be high.
(b) Shareholder’s Equity Ratio: This ratio is calculated as follows :
Shareholde r equity/Total assets (tangible)
The financial strength of a firm can be gauged by the proportion of equity capital in its capital structure, higher the proportion of equity, stronger is the firm’s financial strength. This ratio depicts the relationship between the shareholders equity and the total assets. This ratio also indicates the degree to which unsecured creditors are protected against loss in the event of liquidation. Shareholders equity includes equity and preference capital plus reserves and surplus. An increase in this ratio implies that the dependence of the firm on outside sources of funds is decreasing.
(c) Debt to Net Worth Ratio: This ratio is calculated as follows :
Long term debt/Net worth
This ratio computes long-term debts of the firm to that of net worth. Net worth is calculated as capital and free reserves less fictitious assets like carry forward losses and deferred expenditure. This ratio is a refinement of the debt equity ratio and gives a factual idea of the adequacy of assets to meet long-term liabilities.
(d) Capital Gearing Ratio: It is calculated as follows :
Fixed interest bearing funds/Equity shareholde r funds
This ratio indicates the degree to which the firm is trading on equity that in turn indicates the volatility of earnings available to shareholders. The fixed interest bearing funds includes debentures, long-term loans and preference share capital. Equity shareholders funds include equity share capital, and reserves and surplus.
(e) Fixed Assets to Long-term Funds Ratio: It is calculated as follows :
Debts are raised when owners want to increase investment but are unwilling to dilute the equity or the cost of debt is less than that of equity.There are many ways to calculate this ratio but the most commonly used method is :
Debt equity ratio = Long term debt/ Share holder funds
In other method instead of long term, debts all the debts are taken into consideration. This ratio indicates the relationships between loan funds and net worth of the company that is known as gearing. It also depicts the relative contribution of owners and creditors. A company with a high component of debt capital relative to its equity is known as a highly geared company and vice-versa. There is no standard debt equity ratio and the same will vary from industry to industry. For capital-intensive industries and industries, having a high gestation period this ratio will be high.
(b) Shareholder’s Equity Ratio: This ratio is calculated as follows :
Shareholde r equity/Total assets (tangible)
The financial strength of a firm can be gauged by the proportion of equity capital in its capital structure, higher the proportion of equity, stronger is the firm’s financial strength. This ratio depicts the relationship between the shareholders equity and the total assets. This ratio also indicates the degree to which unsecured creditors are protected against loss in the event of liquidation. Shareholders equity includes equity and preference capital plus reserves and surplus. An increase in this ratio implies that the dependence of the firm on outside sources of funds is decreasing.
(c) Debt to Net Worth Ratio: This ratio is calculated as follows :
Long term debt/Net worth
This ratio computes long-term debts of the firm to that of net worth. Net worth is calculated as capital and free reserves less fictitious assets like carry forward losses and deferred expenditure. This ratio is a refinement of the debt equity ratio and gives a factual idea of the adequacy of assets to meet long-term liabilities.
(d) Capital Gearing Ratio: It is calculated as follows :
Fixed interest bearing funds/Equity shareholde r funds
This ratio indicates the degree to which the firm is trading on equity that in turn indicates the volatility of earnings available to shareholders. The fixed interest bearing funds includes debentures, long-term loans and preference share capital. Equity shareholders funds include equity share capital, and reserves and surplus.
(e) Fixed Assets to Long-term Funds Ratio: It is calculated as follows :
Fixed assets/Long term funds
This ratio indicates the proportion of long-term funds (Share capital reserves and surplus and long-term loans) deployed in fixed assets (gross fixed assets minus depreciation). A high ratio indicates the safety of funds in case of liquidation. This ratio also indicates the proportion of long-term funds invested in working capital.
(f) Proprietary Ratio: It is calculated as follows :
This ratio indicates the proportion of long-term funds (Share capital reserves and surplus and long-term loans) deployed in fixed assets (gross fixed assets minus depreciation). A high ratio indicates the safety of funds in case of liquidation. This ratio also indicates the proportion of long-term funds invested in working capital.
(f) Proprietary Ratio: It is calculated as follows :
Net worth/Total assets
Reserves that are created and earmarked for specific purposes should not be included in the calculation of net worth. A high ratio is an indication of a strong financial position.
(g) Interest Cover: It is calculated as follows :
Profit before interest depreciati on and tax/Interest
The interest coverage ratio reflects the number of times interest charges are covered by the funds that are available for payment of interest.
Generally, a ratio of 2:1 is considered as adequate.
(h) Dividend Cover: It is calculated as follows :
Net profit after tax/Dividend
This ratio indicates the number of times the dividends are covered by net profit. This ratio also highlights the retained earnings.
(i) Debt Service Coverage Ratio: It is calculated as follows :
Profit before interest and taxs/Interest + perodic loan instalment
This ratio reflects the ability of the firm to service its obligations on account of interest payment and loan repayments. A high ratio is an indicator of the fact that the firm is less likely to default on payments.
Reserves that are created and earmarked for specific purposes should not be included in the calculation of net worth. A high ratio is an indication of a strong financial position.
(g) Interest Cover: It is calculated as follows :
Profit before interest depreciati on and tax/Interest
The interest coverage ratio reflects the number of times interest charges are covered by the funds that are available for payment of interest.
Generally, a ratio of 2:1 is considered as adequate.
(h) Dividend Cover: It is calculated as follows :
Net profit after tax/Dividend
This ratio indicates the number of times the dividends are covered by net profit. This ratio also highlights the retained earnings.
(i) Debt Service Coverage Ratio: It is calculated as follows :
Profit before interest and taxs/Interest + perodic loan instalment
This ratio reflects the ability of the firm to service its obligations on account of interest payment and loan repayments. A high ratio is an indicator of the fact that the firm is less likely to default on payments.
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