Solvency Or Leverage Ratios

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Solvency or Leverage Ratios

The solvency or capital structure ratios throw light on the long-term creditors with regard to:

(a) Periodic payment of interest during the period of the loan, and
(b) Repayment of principal on due dates.

Debt-Equity Ratio

It measures the relationship between long-term debt and equity. It gives an idea of the amount of capital supplied to the concern by the proprietors and of asset ‘cushion’ or cover available to its creditors of liquidation.

D.E. Ratio = Long-term Debts / Shareholders’ (Proprietors’) Fund

or D.E. Ratio = Long-term Debts / International Equities

where shareholders’ fund or internal equities include equity capital and reserves and surplus of the company. In other words, it represents the net worth of the company.

Illustration:

Equity capital of a company = Rs 20,00,000
Reserves and surplus = Rs 10,00,000
Long-term debts = Rs 15,00,000

Debt-Equity Ratio = 15,00,000 / 20,00,000 + 10,00,000 = 15,00,000 / 30,00,000 = 1:2

Significance of Debt Equity Ratio. This ratio is ranked with the current ratio in indicating the financial strength of an organization. It measures the ultimate solvency of an enterprise. Theoretically, higher the interest or stake of the shareholders or proprietors as compared with that of the creditors, the more sound would be the financial structure fo the concern. Therefore, the smaller this ratio, the more secured are the creditors. For an industrial concern, a ratio of about 0.33 is considered appropriate. A ratio higher than this is generally treated as an indicator of risky financial policies. The ratio for public utility concerns may, however, be higher than this because in their case, profits are more or less stable.

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