5.Chapter 4: Ratio Analysis : Solvency Ratios: Debt Equity Ratios

Chapter 4
Hello Boys! 
Today, we move further into the chapter taking the next category of Ratios i.e. Solvency Ratios.

Learning Objectives:
Students will be able to:

* Calculate the Solvency Ratio (Debt to Equity Ratio)   
* Know the Significance of the Ratio

Task 
Go through the Debt Equity Ratio study: Given the Formula,Significance, Example and Practice Question

II. Solvency ratios
The persons who have advanced money to the business on long-term basis are interested in safety of their periodic payment of interest as well as the repayment of principal amount at the end of the loan period. Solvency ratios are calculated to determine the ability of the business to service its debt in the long run.

The following ratios are normally computed for evaluating solvency of the business.
1. Debt -Equity ratio
2. Proprietary ratio
3. Total assets to debt ratio
4. Interest coverage ratio
1. Debt Equity ratio measures the relationship between long term debt and shareholders funds. It is computed as long term debts divided by shareholders funds where:

 long term debts (also termed as debt) = non current liabilities

= long term borrowings + other long term liabilities + long term provision

shareholders funds (also termed as equity) = share capital + reserves and surplus + money received against share warrants

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. 

A low ratio reflects more security. If debt component of the total long-term funds employed is small, outsiders feel more secure. 

In other words, from security point of view, capital structure with less debt and more equity is considered favourable as it reduces the chances of bankruptcy.

A High Equity ratio, on the other hand is considered risky as it may put the firm in to difficulty in meeting its obligation 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 Return on Investment is higher than the Rate of Interest payable.
Normally,  it is considered to be safe if Debt Equity Ratio is 2:1. However, it may vary from industry to industry.

Ques 1  (Example)     

From the following Balance sheet of ABC company limited as on 31st March 2020. Calculate debt Equity Ratio:

I. Equity and Liabilities
1. Shareholder's Funds
(a) Share capital                                                    1200000
(b) Reserves and surplus                                        200000
(c) Money received against share warrants          100000
2. Non current liabilities
(a) Long term borrowings                                      400000
(b) Other long term liabilities                                  40000
(c) Long term provisions                                         60000
3.Current liabilities
(a)Short term borrowings                                      200000
(b)Trade payables                                                   100000
(c)Other current liabilities                                       50000
(d)Short term provisions                                         150000

Total                                                                         2500000

II.Assets
1.Non current assets
(a)Fixed assets                                                       1500000
(b)Non current investments                                    200000
(c) Long term loans and advances                          100000
2. Current assets
(a)Current investments                                           150000
(b)Inventories                                                          150000
(c)Trade receivables                                                100000
(d)Cash and cash equivalents                                  250000
(e)Short term loans and advances                             50000

Total                                                                         2500000

Ans.

Debt Equity ratio= long term debts/ shareholders funds
long term debts = long term borrowings + other long term liabilities + long term provisions
= 400000 + 40000 + 60000 = 500000

Shareholders funds = share capital + reserves and surplus + money received against share warrants
=1200000 + 200000 + 100000 = 1500000
therefore, debt equity ratio = 500000/1500000
= 0.33 :1

Task 

Solve the short question given below and note the answer

Calculate Debt Equity Ratio from the following information:

Total assets                        1500000
Current liabilities                600000
Total debts                         1200000