Long Term Solvency Ratios (Leverage Ratios)
Leverage Ratios: It focuses on long-term funds used by the businesses business. Its main objective is to measure the long-term solvency of a firm. Capital Structure Ratios: It focuses on Equity funds, debt capital and, preference capital. Its main objective is to find the portion of risky long-term funds. Coverage Ratios: Its main objective is to find whether the firm's earnings are sufficient to cover different charges like interest for debenture holders and dividends for shareholders.
Table Of Content
A. Capital Structure Ratios
1) Equity Ratio
This ratio indicates the proportion of owners' funds to the total funds invested in the business. It is also called the propriety ratio. Shareholder's equity = share capital ( both equity and preference ) + Reserve and surplus - Accumulated losses OR, Shareholder's equity = Total assets - current liabilities - long-term debt. If the majority of the fund of the business is funded by the shareholder then there is a low degree of risk.
2) Debt Ratio
Total capital Employed = Shareholder's Equity ( both preference and Equity ) + Long Term Debt. This ratio is used to analyze the long-term solvency of a firm.
3) Debt to Equity Ratio
This ratio indicates the relative proportion of debt and equity in financing the assets of the firm. In other words, it is the ratio of the amount invested by outsiders to the amount invested by the owners of the business. The debt to equity ratio is also called the financial leverage ratio. High debt to equity ratio means less protection for long-term creditors. In other words, low debt to equity ratio indicates a wider safety for long-term creditors. Debt to equity fund indicates the proportion of debt fund about equity. Debt equity is the indicator of financial leverage.
4) Capital Gearing Ratio
This ratio indicates or measures the proportion of fixed interest (dividend) bearing capital to funds belonging to equity shareholders. The gearing ratio indicates how much of the business is funded by borrowing. Higher the level of borrowing, higher the risks to the business, since the payment of interest and repayment of debts are not optional in the same way as dividends. however, gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows.
B. Coverage Ratios
1) Interest Coverage Ratio
let's understand it with an example. Let us suppose Arun kabeli Power limited has earnings before interest and tax (EBIT) of RS 10,00,000 and it has taken a loan from Global IME Bank of RS 20,00,000 at the rate of 12%. It means Arun Kabeli Power limited has to pay Rs 2,40,000 as interest. The interest coverage ratio of Arun Kabeli Power limited will be 4.16 times. It denotes Arun Kabeli Power Limited has Rs 10,00,000 and It has to pay interest of RS 2,40,000 which means Arun Kabeli has enough funds to pay the interest of the bank. A high-interest coverage ratio means that a company can easily meet its interest obligations even if earning before interest and taxes suffer a considerable decline. A lower ratio indicates excessive use of debt or inefficient operation. The interest coverage ratio is also known as the time's interest earned (TIE) ratio which indicates the firm ability to meet interest obligations.
2) Preference Dividend Coverage Ratio
This ratio measures the ability of a firm to pay dividends on preference shares that carry a stated rate of return. This ratio indicates the margin of safety available to the preference shareholders. A higher ratio is desirable from the preference shareholders' point of view. EAT stands for earnings before tax.
3) Debt Service Coverage Ratio
Debt service coverage ratio measures or judges the firm ability to pay off current interest and installments. The higher the ratio, the More is the margin of safety for the lenders.
Conclusion
All the above-mentioned ratios are the fundamental ratio of the company. Before investing in any company you have to study about leverage ratio of the concerned company. You can get such information from the annual report of the company. But only leverage ratio is not sufficient, you have to check other important ratios because only one ratio cannot tell whether the company is good or not. Therefore you have to look at fundamental ratios like liquidity (short-term solvency ratios) and other important shareholders ratios. Your decision should be based on actual fact facts and figures and the corporate governance of the company.
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