Ratio analysis - Leverage Ratios

Leverage Ratios or Solvency Ratios or Capital Structure Ratios

Leverage or Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is solvent and well capable of paying off its debt obligations or not. These ratios are used to measure the long term financial position as a test of solvency of an organisation.

The types of Leverage ratios are: –
Proprietary Ratio or Equity Ratio
Equity to Fixed Asset Ratio
Equity to Current Assets Ratio
Current Liabilities to Shareholders Funds Ratio
Debt Equity Ratio
Capital Gearing or Leverage Ratio

1. MANAGEMENT ACCOUNTING Ratio Analysis By: Smt.UMA MINAJIGI REUR HEAD, DEPT. OF COMMERCE & Management Smt. V G Degree College for Women, Kalaburagi

2. MANAGEMENT ACCOUNTING Ratio Analysis Leverage ratios - 1

3. An analysis of financial statements with the help of ratio is called Ratio Analysis. Ratio refers to Numerical or Quantitative relationship between two items. What are Financial Ratios? Financial ratios are created with the use of numerical values taken from  financial statements  to gain meaningful information about a company. The numbers found on a company’s financial statements –  balance sheet ,  income statement , and  cash flow statement  – are used to perform  quantitative analysis  and assess a company’s liquidity, leverage, growth, margins, profitability, rates of return, valuation, and more.

4. Ratio analysis is a process used for the calculation of financial ratios or in other words, for the purpose of evaluating the financial wellbeing of a company. The values used for the calculation of financial ratios of a company are extracted from the financial statements of that same company. Ratio analysis can be defined as the process of ascertaining the financial ratios that are used for indicating the ongoing financial performance of a company using few types of ratios such as liquidity, profitability, activity, debt, market, solvency, efficiency, and coverage ratios and few examples of such ratios are return on equity, current ratio, quick ratio,  dividend payout ratio , debt-equity ratio, and so on.

5. Classification of Accounting Ratio Types of ratios are given below: Liquidity Ratios Leverage Ratio Turnover Ratio Profitability Ratio

6. Leverage Ratios or Solvency Ratios or Capital Structure Ratios Leverage or Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is solvent and well capable of paying off its debt obligations or not. These ratios are used to measure the long term financial position as a test of solvency of an organisation. The types of Leverage ratios are: – Proprietary Ratio or Equity Ratio Equity to Fixed Asset Ratio Equity to Current Assets Ratio Current Liabilities to Shareholders Funds Ratio Debt Equity Ratio Capital Gearing or Leverage Ratio

7. 1. Proprietary Ratio or Equity Ratio or Total Assets Ratio :   The ratio establishes the relationship between shareholder’s funds and total assets of a firm. Shareholder’s Funds: Paid-up equity capital Preference Share Capital Reserves Profit & Loss (Credit Balance) Total Assets : Fixed Assets + Current Assets Proprietary   Interpretation: Standard Ratio is 5:1 If ratio is high it indicates strong in financial position. If ratio is low it indicates weak in financial position.

8. From the following information calculate the proprietary ratio: Equity Share capital 3,00,000 Fixed Assets 3,57,000 Preference Share Capital 1,50,000 Current Assets 1,50,000 Reserves 75,000 Investments 2,25,000 Debentures 1,80,000 Creditors 45,000 7,50,000 7,50,000 Proprietary  

9. From the following information calculate the proprietary ratio: Equity Share capital 3,00,000 Fixed Assets 3,57,000 Preference Share Capital 1,50,000 Current Assets 1,50,000 Reserves 75,000 Investments 2,25,000 Debentures 1,80,000 Creditors 45,000 7,50,000 7,50,000 Solution: 1) Calculation of Shareholder’s Funds : 2) Calculation of Total Assets : Equity Share capital 3,00,000 Fixed Assets 3,57,000 Preference Share Capital 1,50,000 Current Assets 1,50,000 Reserves 75,000 Investments 2,25,000 5,25,000 7,50,000 Calculation of Total Funds: Equity Share capital 3,00,000 Preference Share Capital 1,50,000 Reserves 75,000 Debentures 1,80,000 7,05,000

10. Solution: 1) Calculation of Shareholder’s Funds : 2) Calculation of Total Assets : Equity Share capital 3,00,000 Fixed Assets 3,57,000 Preference Share Capital 1,50,000 Current Assets 1,50,000 Reserves 75,000 Investments 2,25,000 5,25,000 7,50,000 Proprietary   Proprietary   Proprietary  

11. 2 . Equity to Fixed Assets Ratio :   The ratio establishes the relationship between Net fixed assets of the firm and Owner’s finds. Shareholder’s Funds or Owner’s Equity: Paid-up equity capital Preference Share Capital Reserves Profit & Loss (Credit Balance) Fixed Assets Equity to Fixed Assets Ratio   Interpretation: Standard Ratio is 2/3 or 67% If ratio is high it indicates strong in financial position. If ratio is low it indicates weak in financial position.

12. 3 . Equity to Current Assets Ratio :   The ratio establishes the relationship between current assets of the firm and Shareholder’s finds. (Current Assets to Shareholders Funds ) Shareholder’s Funds or Owner’s Equity: Paid-up equity capital Preference Share Capital Reserves Profit & Loss (Credit Balance) Current Assets Equity to Current Assets Ratio   Interpretation: No Standard Ratio If ratio is high it indicates strong in financial position. If ratio is low it indicates weak in financial position.

13. 4 . Current Liabilities to Shareholders’ funds Ratio :   The ratio establishes the relationship between current liabilities of the firm and Shareholder’s finds. Shareholder’s Funds or Owner’s Equity: Paid-up equity capital Preference Share Capital Reserves Profit & Loss (Credit Balance) Current Liabilities Current Liabilities to Shareholders’ funds Ratio   Interpretation: Standard Ratio is 1/2 If the actual ratio is more than standard ratio, it would be difficult for the concern to obtain long term funds.

14. 5 . Debt Equity Ratio :   The ratio establishes the relationship between long term debts (external liabilities) and Shareholder’s finds (internal liabilities). It is a ratio of borrowed capital to the owned capital. It is calculated as follows: Debt Equity Ratio   External Equities include all debts. Internal Equities (Shareholders’ Funds) include: Shareholder’s Funds or Owner’s Equity: Paid-up equity capital XXX Preference Share Capital XXX Reserves XX Profit & Loss (Credit Balance) XX XXX Less: Deferred expenses X Losses X X Shareholders’ Funds XX

15. 5 . Debt Equity Ratio :   The ratio establishes the relationship between long term debts (external liabilities) and Shareholder’s finds (internal liabilities). It is a ratio of borrowed capital to the owned capital. It is calculated as follows: Interpretation: Standard Ratio is 2:1 If the debt ratio is less than 2 times of equity, it indicates that the financial structure of the concern is sound. If the debt ratio is more than 2 times of equity, it indicates that the financial structure of the concern is weak. Debt Equity Ratio  

16. Illustration 6: Calculate debt equity ratio, Total assets Rs.2,50,000, Total Debt Rs. 1,50,000, Current Liabilities Rs.50,000. Debt Equity Ratio   External Equities include all debts. Total Debt = Long Term Debts + Current Liabilities 1,50,000 = Long Term Debts + 50,000 Long Term Debts = 1,50,000 - 50,000 = 1,00,000 Shareholder’s Funds or Owner’s Equity: Total Assets 2,50,000 Less: Total Liabilities 1,50,000 Shareholders’ Funds 1,00,000 Solution 6: Debt Equity Ratio  

17. Exercise 36: From the following information calculate the debt equity ratio. 20,000 equity shares of Rs.10 each 2,00,000 General Reserves 1,00,000 Accumulated profits 80,000 12% Debentures 2,50,000 10% Preference Share Capital 1,00,000 Trade Creditors 80,000 Outstanding Expenses 10,000 Provision for taxation 20,000

18. Exercise 36: From the following information calculate the debt equity ratio. Debt Equity Ratio   External Equities include all debts. 12% Debentures 2,50,000 2,50,000 Shareholder’s Funds or Owner’s Equity: 20,000 equity shares of Rs.10 each 2,00,000 General Reserves 1,00,000 Accumulated profits 80,000 10% Preference Share Capital 1,00,000 4,80,000 Solution 36: Debt Equity Ratio   From the following information calculate the debt equity ratio. 20,000 equity shares of Rs.10 each 2,00,000 General Reserves 1,00,000 Accumulated profits 80,000 12% Debentures 2,50,000 10% Preference Share Capital 1,00,000 Trade Creditors 80,000 Outstanding Expenses 10,000 Provision for taxation 20,000

19. 6 . Capital Gearing or Leverage Ratio :   The ratio establishes the relationship between fixed interest bearing securities and Equity Shareholder’s finds . It is calculated as follows: Capital Gearing Ratio   Fixed Interest bearing securities: These securities carry with them the fixed rate of dividend or interest. Fixed Interest bearing securities include: Long Term Loans Debentures Long term fixed deposits Preference Share Capital Shareholder’s Funds or Owner’s Equity: Equity Share capital Reserves Profit & Loss (Credit Balance)

20. Interpretation: High ratio: Highly Geared If the capital gearing ratio is high, it is attractive proportion to the investors. It shows that the major share of total capital is in the form of fixed interest bearing securities. If the ratio is more than one, it is said to be highly geared. Low ratio: Low Geared If the capital gearing ratio is low, it is not attractive proportion to the investors. If the ratio is less than one, it is said to be low geared. In such cases fixed interest bearing securities are less in total capital, i.e , less than equity capital. Evenly Geared: If the ratio is exactly one , it is said to be evenly geared.

21. Illustration 7: From the following information calculate capital gearing ratio. 15% Preference share capital 12,50,000 12% Debentures 12,50,000 Equity Share Capital 3,00,000 Reserves & Surplus 2,50,000 Preliminary expenses 50,000 Capital Gearing Ratio   Fixed Interest bearing securities: Long Term Loans Debentures Long term fixed deposits Preference Share Capital Shareholder’s Funds or Owner’s Equity: Equity Share capital Reserves Profit & Loss (Credit Balance) Solution 7:

22. Illustration 7: From the following information calculate capital gearing ratio. 15% Preference share capital 12,50,000 12% Debentures 12,50,000 Equity Share Capital 3,00,000 Reserves & Surplus 2,50,000 Preliminary expenses 50,000 Capital Gearing Ratio   Fixed Interest bearing securities: 15% Preference Share Capital 12,50,000 12% Debentures 12,50,000 Long Term Loans -- Long term fixed deposits -- 25,00,000 Shareholder’s Funds or Owner’s Equity: Equity Share capital 3,00,000 Reserves 2,50,000 Profit & Loss (Credit Balance) ---- 5,50,000 Less: Preliminary Exp 50,000 5,00,000 Solution 7: Capital Gearing Ratio = = 5:1  

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