Long term solvency ratios

Long term solvency ratios

Long term solvency means the firm’s ability to meet its liabilities in the long run. Long term solvency ratios help to determine the ability of the business to repay its debts in the long run. The following ratios are normally computed for evaluating long term solvency of the business:

i.            Debt equity ratio

ii.            Proprietary ratio

iii.            Capital gearing ratio

(i) Debt equity ratio

Debt equity ratio is calculated to assess the long term solvency position of a business concern.

Debt equity ratio expresses the relationship between long term debt and shareholders’ funds.

It is computed as follows:

Debt equity ratio = Long term debt / Shareholders'funds

In general, lower the debt equity ratio, lower is the risk to the long-term lenders. A high ratio indicates high risk as it may be difficult for the business concern to meet the obligation to outsiders.

Illustration 4

From the following information, calculate debt equity ratio:

Solution

Debt equity ratio = Long term debt/Shareholders'funds  = 80,000/1,60,000 = 0.5:1

Long term debt = Debentures = ₹ 80,000

Shareholders’ funds = Equity share capital + Reserves and surplus

= 1,00,000 + 60,000 = ₹ 1,60,000

(ii) Proprietary ratio

Proprietary ratio gives the proportion of shareholders’ funds to total assets. Proprietary ratio shows the extent to which the total assets have been financed by the shareholders’ funds. It is calculated as follows:

Higher the proprietary ratio, greater is the satisfaction for lenders and creditors, as the firm is less dependent on external sources of finance.

Illustration 5

From the following Balance Sheet of Pioneer Ltd. calculate proprietary ratio:

Solution

Proprietary ratio = Shareholders'funds / Total assets = 2,00,000 / 4,00,000 = 0.5:1

Shareholders’ funds = Equity share capital + Preference share capital + Reserves and surplus

= 1,00,000 + 75,000 + 25,000

= ₹ 2,00,000

(iii) Capital gearing ratio

Capital gearing ratio is the proportion of fixed income bearing funds to equity shareholders’ funds. Fixed income bearing funds include fixed interest and fixed dividend bearing funds. It is calculated as follows:

Capital gearing ratio = Equity shareholders'funds / Funds bearing Fixed interest or Fixed dividend

Capital gearing ratio is a measure of long term solvency as well as capital structure. When the capital gearing ratio is greater than one, the firm is said to be high geared.

Illustration 6

From the following information calculate capital gearing ratio:

Funds bearing fixed interest and dividend = 6% Preference share capital + 8% Debentures

= 1,00,000 + 2,00,000 = ₹ 3,00,000

Equity shareholder’s funds = Equity share capital + General reserve + Surplus

= 2,00,000 + 1,25,000 + 75,000 = ₹ 4,00,000

Illustration 7

From the following Balance Sheet of Arunan Ltd. as on 31.03.2019 calculate (i) Debt-equity ratio (ii) Proprietary ratio and (iii) Capital gearing ratio.

Solution

Funds bearing fixed interest or dividend    = 8% Preference share capital + 9% Debentures

= 2,00,000 + 4,00,000 = ₹ 6,00,000 

Equity shareholders’ funds = Equity share capital + Reserves and surplus

= 1,50,000 + 1,50,000 = ₹ 3,00,000