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.
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
- Capital Structure Ratios
- 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.
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
= 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
= Total Outside Liabilities/Shareholder’s Equity
= 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
= 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)
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
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.
- Equity Ratio = Shareholder’s Equity/Capital Employed
Shareholder’s Equity = Share Capital + General Reserves + Surplus
= 2000000 + 400000 – 90000
Capital Employed = Total Assets – Current Liabilities
= 2200000 – 240000
Debt to Equity Ratio =Long-term Debts/Shareholder’s Equity
- Debt to Total Assets Ratio = Total Debt/Total Assets