In our earlier posts we have discussed Profitability Ratios and Liquidity Ratios. The capacity of the business to meet its short-term and long term obligations can be generalized into the term “Solvency”. Creditors, bank loans and bills payable etc come under the inclusion of Short Term obligations. Long-term obligations broadly encompass - debenture, long-term loans and long-term creditors etc. Solvency Ratios are an indication of the financial soundness of a business to continue the operations of its business smoothly, without any impediments and meet its all obligations.
Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency of the concern have already been explained. Now under this part of the chapter only the long-term solvency ratios are dealt with. Some of the important ratios which are given below in order to determine the solvency of the concerned:
Debt - Equity Ratio
Capital Gearing Ratio
Debt Service Ratio or Interest Coverage Ratio
This ratio is designed to ascertain the firm's obligations to creditors in relation to funds invested by the owners. It is an indication of all external liabilities to owner’s recorded claims.
Debt – Equity Ratio = Total Long Term Debts / Shareholders Fund
Proprietary Ratio is also termed as Capital Ratio or Net Worth to Total Asset Ratio. It serves as one of the variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth. The relationship between shareholders' fund and total assets is formed by this ratio.
Proprietary Ratio = Shareholders Fund/ Total Assets
This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term capital gearing refers to describe the relationship between fixed interest and/or fixed dividend bearing securities and the equity shareholders' fund.
Capital Gearing Ratio = Equity Share Capital / Fixed Interest Bearing Funds
Debt Service Ratio is also termed as Interest Coverage Ratio or Fixed Charges Cover Ratio. This ratio denotes the equation between the amount of net profit before deduction of interest and tax and the fixed interest charges. It is used as a yardstick for the lenders to gain an insight that the business concern will be able to pay its interest periodically.
Debt Service Ratio or Interest Coverage Ratio = Net profit before Interest & Taxes / Fixed Interest Charges
The overall profitability of a firm on the extent of operating efficiency it enjoys. This ratio establishes the relationship between profitability on sales and the profitability on investment turnover.
Overall Profitability Ratio = Net Profit / Total Assets
The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
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