What are those various ratios that are likely to help the management in forming the opinion about the solvency position of the firm. Explain them with suitable examples.
Ratios those help management in forming the opinion about financial solvency about business are called “Solvency Ratios”. 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
- Proprietary Ratio
- Capital Gearing Ratio
- Debt Service Ratio or Interest Coverage Ratio
1. Debt – Equity 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.
2. Proprietary Ratio
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.
3. Capital Gearing Ratio
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.
4. Debt Service Ratio or Interest Coverage Ratio
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.