In view of the coronavirus pandemic, we are making LIVE CLASSES and VIDEO CLASSES completely FREE to prevent interruption in studies
Accounting Ratios

Leverage Ratios

We know that accounting ratio is a mathematical relationship between two interrelated financial variables. Hence, Ratio analysis is the process of interpreting the accounting ratios and taking decisions on this basis. We calculate the Liquidity ratios to measure short-term liquidity. For measuring long-term liquidity, we calculate Capital Structure and Coverage Ratios.

Suggested Videos

Play
Play
Arrow
Arrow
ArrowArrow
Objectives of Business
Levels of Management
Slider

 

Leverage Ratios

A business requires funds in order to meet its long-term contractual obligations. Solvency is the ability of an organization to pay the amount due to the external stakeholders.

In order to measure the long-term stability and structure of an organization, we calculate the Leverage Ratios. As these measures the solvency position of an entity, we also call them Solvency Ratios.

These are long-term in nature. Leverage Ratios or Solvency Ratios measure the mix of funds provided by the owners and the lenders. They ensure the lenders of long-term funds regarding the payment of interest on loan periodically and repayment of principal amount of loan on maturity.

Types of Leverage Ratios

  1. Capital Structure Ratios
  2. Coverage Ratios

Let us study these ratios in detail.

Capital Structure Ratios

These ratios provide an understanding of the financing techniques of an entity and concentrate on the long-term solvency position of the business.

These show the proportional weight of different sources of funds. Whereas, the Balance Sheet shows only the absolute fund employment and their sources. Types of Capital Structure Ratios are:

Equity Ratio

It measures the proportion of the owner’s funds to the total funds employed in the business. Higher the Equity Ratio lower is the degree of risk.

Equity Ratio = Shareholder’s Equity/Capital Employed

 

Where, Shareholder’s Equity = Share Capital + General Reserves + Surplus + Retained Earnings

Capital Employed = Total Assets – Current Liabilities

Or

= Fixed Assets + Working Capital

Debt to Equity Ratio

It measures the proportion of debt fund in relation to the equity funds. In other words, it indicates the financial leverage of the firm. The management refers to this ratio for taking capital structure decisions.

A high Debt Equity Ratio indicates that creditors are at risk while the low indicates that there is a wide safety cushion. Here, Shareholder’s Equity includes equity and preference share capital and post accumulated profits but excludes fictitious assets.

Debt to Equity Ratio = Long-term Debts/Shareholder’s Equity

Or

= Total Outside Liabilities/Shareholder’s Equity

Or

= Total Debts/Shareholder’s Equity

Debt to Total Assets Ratio

It measures the proportion of total assets to debt. It means it indicates the total assets that are financed with debts. Higher the Debt to Total Assets Ratio higher is the risk of investment. A lower ratio is preferable.

Total debt or outside liabilities include short-term and long –term borrowings from financial institutions, banks, debentures, bonds, etc. It is noteworthy here that in case a question does not mention anything, we will consider only the long-term borrowings.

Debt to Total Assets Ratio = Total Debt/Total Assets

Or

= Total Outside Liabilities/Total Assets

Where, Total Assets = Current Assets + Non-current Assets

Capital Gearing Ratio

It measures the proportion of fixed interest or dividend bearing capital to funds of equity shareholders. When equity shareholder’s funds are more than the fixed interest-bearing funds, we say that a company is low geared and vice-a-versa.

Capital Gearing Ratio =(Preference Share Capital + Debentures + Other Borrowed Funds)/(Equity Share Capital + Reserves and Surplus – Losses)

Proprietary Ratio

It measures the proportion of total assets financed by equity and preference shareholders.

Proprietary Ratio = Proprietary Fund/Total Assets

Where, Proprietary Fund = Equity Share Capital + Preference Share Capital + Reserves and Surplus

 

Coverage Ratios

Coverage Ratios

These measure the proportion of fixed claims to what is available to pay them out. Interest on loans, preference dividend, amortization of principle or repayment of loan instalments and redemption of preference capital are some of the fixed claims. Various coverage ratios are:

Debt Service Coverage Ratio

It helps the lenders to analyze the entity’s ability to pay off current instalments and interest.

Debt Service Coverage Ratio = (Earnings available for Debt Services)/(Interest liabilities + Installments)

Where, Earnings available for Debt Services = Net profit after tax + Non-Cash operating expenses like depreciation + Interest + Other adjustments like the loss on sale of fixed assets, etc.

Interest Coverage Ratio

It shows the entity’s ability to meet the interest and other fixed obligations. A high-Interest Coverage Ratio is preferable.

Interest Coverage Ratio = E.B.I.T. (Earnings before interest and tax)/Interest

Preference Dividend Coverage Ratio

It shows the ability of the entity to pay the dividend to preference shareholders at a fixed rate. We consider Earnings after tax because preference dividend is not an expense but an appropriation of profit. A higher ratio is desirable.

Preference Dividend Coverage Ratio = E.A.T. (Earnings after tax)/Preference dividend liability

Equity Dividend Coverage Ratio

It shows the ability of the entity to pay a dividend to equity shareholders. We consider Earnings after tax less preference dividend because we pay the dividend to equity shareholders only after the payment to preference shareholders.

Equity Dividend Coverage Ratio =  (E.A.T. – Preference Dividend)/Equity Fund

Fixed Charges Coverage Ratio

It measures how many times the cash flow before interest and tax covers all fixed financing charges. Fixed Charges Coverage Ratio of more than 1 is good.

Fixed Charges Coverage Ratio = (E.B.I.T. + Fixed charges before tax)/(Interest + Fixed charges before tax)

 Solved Example For You

From the following particulars calculate Equity Ratio, Debt to Equity Ratio and Debt to Total Assets Ratio.

Particulars Amount
Share Capital 2000000
Reserves 400000
Surplus (90000)
Creditors 240000
Current Assets 1000000
Non-Current Assets 1200000
Long-term liabilities 330000

Ans.

  1. Equity Ratio = Shareholder’s Equity/Capital Employed

= \(\frac{2310000}{1960000}\)

= 1.18:1

Shareholder’s Equity = Share Capital + General Reserves + Surplus

= 2000000 + 400000 – 90000

= 2310000

Capital Employed = Total Assets – Current Liabilities

= 2200000 – 240000

= 1960000

 

Debt to Equity Ratio =Long-term Debts/Shareholder’s Equity

= \(\frac{330000}{2310000}\)

= 0.14:1

  1. Debt to Total Assets Ratio = Total Debt/Total Assets

= \(\frac{330000}{2200000}\)

= 0.15:1

 

Share with friends

Customize your course in 30 seconds

Which class are you in?
5th
6th
7th
8th
9th
10th
11th
12th
Get ready for all-new Live Classes!
Now learn Live with India's best teachers. Join courses with the best schedule and enjoy fun and interactive classes.
tutor
tutor
Ashhar Firdausi
IIT Roorkee
Biology
tutor
tutor
Dr. Nazma Shaik
VTU
Chemistry
tutor
tutor
Gaurav Tiwari
APJAKTU
Physics
Get Started

Leave a Reply

avatar
  Subscribe  
Notify of

Stuck with a

Question Mark?

Have a doubt at 3 am? Our experts are available 24x7. Connect with a tutor instantly and get your concepts cleared in less than 3 steps.
toppr Code

chance to win a

study tour
to ISRO

Download the App

Watch lectures, practise questions and take tests on the go.

Get Question Papers of Last 10 Years

Which class are you in?
No thanks.