28 Long term Financial Analysis and capital Structure Ratios

Deepika Gautam

LEARNING OBJECTIVES:

This modules help to understand the concept of solvency of the firm to meet its long term obligations. Long-term solvency ratios indicate a firm’s ability to meet the fixed interest and costs and repayments schedules associated with its long term borrowings. The various ratios like Debt-equity ratio, Proprietary ratio, fixed Assets ratio, interest Coverage ratio and cash to debt service ratio serve the purpose of determine the solvency of the concern. Capital structure of the firm is equally important as it depicts the mixture of debt and equity and refers to the relationship between various long-term forms of financing and various ratios are used by any company to analyze the capital structure of a firm like leverage ratios, Ratio of reserves to equity capital and a concept of DU-PONT CONTROL chart which is used by the firm to compare the present ratios and comment on the performance.

INTRODUCTION:

The term solvency refers to the ability of a concern to meet its long term obligations and long term indebtedness of a firm includes debenture holders, financial institutions providing medium and long term loans and other creditors selling goods on installment basis. The long-term creditors of a firm are primarily interested in knowing the firm’s ability to pay regularly interest on long-term borrowings, repayment of the principal amount at the maturity and the security of their loans. Accordingly, long term-term solvency ratios indicate a firm’s ability to meet the fixed interest and costs and repayment schedules associated with its long-term borrowings.

The following ratios serve the purpose of determining the solvency of the concern.

A. Solvency Ratios

Test of Solvency

1. Debt Equity Ratio

2. Funded-Debt to Total Capitalization Ratio

3. Equity Ratio

4. Solvency Ratio

5. Fixed Assets to Net Worth Ratio

6. Fixed Assets to Long Term Fund Ratio

7. Rate of Current Asset to Proprietor’s Funds

8. Debt Service Ratio

9. Cash to Debt –Service Ratio

Brief explanation of each ratio in detail:

1. DEBT-EQUITY RATIO:

Debt-Equity Ratio is also known as External-Internal Equity ratio and it is calculated to measure the relative claims of outsiders and the owners against the firm’s assets. This ratio indicates the relationship between the external equities and the internal equities.

Debt-Equity Ratio = Outsiders Funds/ Shareholders’ Funds Or External Equities/Internal Equities

The two basic components of the ratio are outsider’s funds and shareholder’s fund.

Interpretation of Debt-Equity Ratio:

The Debt financing used in a business can be measure with the help of this ratio. The proportionate claims of owners and the outsiders against the firm’s assets can be indicated with the help of this ratio. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. It is advisable to have an appropriate mix of owners’ funds and outsiders’ funds in financing the firm’s assets. A high debt ratio indicates that the claims of outsiders are greater than those of owners, so it is not considered favorable whereas from the long –term creditors’ point of view a low debt ratio is considered favorable. As such there is no rule of thumb but in some businesses a high ratio of 2:1 or even more may be considered satisfactory and sometime a ratio of 1:1 may be considered satisfactory.

2. FUNDED DEBT TO TOTAL CAPITALIZATION RATIO: A link establishes between the long-term funds raised from outsiders and total- long term funds available in the business is reflected by this ratio. The two components which are basically used in this ratio are Funded Debt and Total Capitalization.

Funded Debt = Debentures + Mortgage loans + Bonds + Other long-term loans

Total Capitalization = Equity share capital + Preference share capital + Reserves & surpluses + Debentures + Mortgage loans + other long term loans

Funded Debt to Total Capitalization Ratio = Funded debt/ Total Capitalization* 100

There is no rule of thumb but ideally the lesser the reliance on outsider the better it will be. Up to 50% or 55% this ratio is tolerable but beyond that it may create problems to the business.

3. EQUITY RATIO: This ratio is also known as shareholders ratio and proprietor ratio or net worth to total assets ratio. This ratio establishes the relationship between shareholders’ fund to total assets of the firm. Shareholders’ Funds or Proprietors’ Funds and Total Assets are the components of this ratio.

Shareholders’ Funds = Equity Share capital, Preference Share capital, undistributed profits reserves & surpluses.

Total Assets = Total resources of the concern

Equity Ratio = Shareholders’ Fund/ Total Assets

Interpretation of this Ratio: This ratio represent the relationship of owner’s funds to total assets, higher the ratio, better is the long term solvency position of the company. This ratio indicates the extent to which the assets of the company can be used without affecting the interest of creditors of the company.

Example:

Shareholders’ Fund are Rs 4,00,000 and Total Assets are Rs 6,00,000 Equity Ratio = Shareholders’ Fund/ Total Assets

Equity Ratio = 8,00,000/4,00,000 = 2:3

This ratio can also be represented in % which indicates the % of owner’s capital to total capital of the firm.

Equity Ratio = 4,00,000/6,00,000*100 = 66.67%

4. SOLVENCY RATIO: This ratio is a very small variant of equity ratio and can be simply calculated as 100- equity ratio and this ratio indicates the relationship between the total liabilities of the firm to total assets of a firm and can be calculated as follows:

Solvency Ratio = Total Liabilities to Outsiders/Total Assets

Generally, lower the ratio of total liabilities to total assets, more satisfactory or stable is the long-term solvency position of a firm.

5. FIXED ASSETS TO NET WORTH RATIO: This ratio establishes the relationship between fixed assets and shareholders’ funds. The fixed assets are to be considered after deducting the amount of depreciation (decrease in the value of the assets) from the respective assets.

Fixed Assets to Net Worth Ratio = Fixed Assets (after depreciation)/Shareholders’ Fund

This ratio indicates the extent to which shareholders’ funds are sunk into the fixed assets. Generally, the purchase of fixed assets should be financed by shareholders’ equity including reserves, surpluses and retained earnings. If this ratio is less than 100 5, it implies that owner’s funds are more than total fixed assets and a part of the working capital is provided by the shareholders. When the ratio is more than 100%, it means that owners’ funds are not sufficient to meet the liability to finance the fixed assets and the firm has to depend upon outsiders to finance the fixed assets.

There is no rule of thumb but to interpret this ratio 60 to 65% is considered to be satisfactory.

6. FIXED ASSETS TO LONG TERM FUND RATIO: A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to total long term funds which is calculated as follows:

Fixed Assets Ratio = fixed Assets (after depreciation)/ Total long term funds.

This ratio indicates the extent to which the total of fixed assets is financed by long term funds of the firm. Generally, the total of the fixed assets should be equal to the total of the long-term funds. But in case the fixed assets exceed the total of the long term funds it implies that the firm has financed a part of the fixed assets out of current funds or the working capital which is not a good financial policy and if the total long term funds are more than total assets, it means that a part of the working capital requirement is met out of the long term funds of the firms.

7. RATE OF CURRENT ASSET TO PROPRIETOR’S FUNDS: This ratio is calculated by dividing the total of current assets by the amount of shareholders’ fund. This ratio indicates the extents to which proprietors’ fund are invested in current assets. There is no rule of thumb for this ratio and depending upon the nature of the business there may be different ratios for different firms.

Rate of Current Asset to Proprietor’s Fund Ratio can be calculated as follows = Current Assets/ Shareholders’ Funds * 100

8. DEBT SERVICE RATIO: Net income to debt service ratio or simply debt service ratio is used to test the debt- servicing capacity of a firm. This ratio is also known as Interest Coverage Ratio or Coverage Ratio or Fixed Charges. This ratio is calculated as follows:

Debt Service Ratio = Net profit (Before interest and taxes)/Fixed interest Charges

Example:

The net profit after tax of a firm is Rs 50,000 and its fixed interest charges on long-term borrowings are Rs 11,000. The rate of income tax is 50%. Calculate interest coverage ratio.

Solution:

Interest Coverage Ratio= Net Profit (before interest and taxes)/Fixed interest charges

Interest Coverage Ratio = 50,000 +50,000 + 10,000/10,000 Interest Coverage Ratio = 11 times.

Interpretation of this Ratio: This ratio indicates the number of times interest is covered by the profits available in the business. In other words, the capability of the company to pay the interest charges is also interpreted by this ratio. Long-term creditors of a firm are interested in knowing the firm’s ability to pay interest on their long term borrowing. Generally, higher the ratio, safer is the long term creditors because even if the earnings of the firm fall, the firm shall be able to meet its commitments of fixed interest charges. But a too high ratio may not be good for the firm because it may imply that firm is not using debt as a source of finance so as to increase the earning per share. One of the limitations of Interest Coverage Ratio is that it does not take into consideration other fixed obligations like payment of preference dividend (These shareholders are entitled to receive the fixed rate or amount of dividend irrespective of the availability of or quantum of profit) a repayment of loan installments (Irrespective of the financial position of the concern installment of loan is to be paid by the company) .

Total Coverage or Fixed Charge Coverage = Net profit before interest and taxes/ Total fixed Charges

9. CASH TO DEBT –SERVICE RATIO: Cash to debt service ratio also known as Debt Cash Flow Coverage Ratio, it is an improvement over the Interest coverage ratio. The logic of this ratio is that the interest payments are to be made out of cash inflow of the business and not profits and apart from interest expenses sinking fund appropriations on debt (which are generally made by various firms to enable itself to make repayment of the loans) should be considered to find out debt cash flow coverage as a measure of long term solvency of a firm.

Higher the coverage better it is, as far as, long term solvency of the firm is concerned

Cash to Debt –Service Ratio = Annual Cash Flow before interest and taxes

Interest + Sinking Fund Appropriation on Debt

I- Tax rate

CF = Annual cash flow interest and tax

I = Interest charges

SFD = Sinking Fund Appropriation on Debt

T = Rate of Tax

Example:

A company is currently earnings an EBIT of Rs 24,00,000. Its present borrowings are:

11% term loans		50 lakhs
Working Capital:
Borrowings from bank @ 16%	33 lakhs
Public Deposit	@ 12%	25 lakhs
Calculate total interest
*Solution*:
11% on term loan of Rs	550,000
16% on bank borrowings	528,000
12% on public deposits	3,00,000
Total Interest		1,378,000

B. MARKET TEST RATIOS:

(i) DIVIDEND YIELD RATIO: Dividend is the amount which is received by the shareholders as a part of the profit. Preference shareholders are entitled to receive fixed rate of dividend, whereas equity shareholder gets the dividend after payment to preference shareholder. This ratio is calculated to evaluate the relationship between dividend per share paid and the market value of the share.

Dividend Yield Ratio = Dividend per Share/ Market value per share Dividend per share = Dividend paid to shareholders/Number of shares

(ii) PRICE EARNINGS RATIO: It is the ratio between market price per equity share and earnings price per share. The ratio is calculated to make an estimate of appreciation in the value of a share of a company and is widely used by investors to decide whether or not to buy shares in a particular company. The ratio is calculated as:

Price Earnings Ratio = Market price per equity share/Earnings per share Generally higher the price earnings ratio, the better it is.

(iii) EARNING YIELD RATIO: This ratio shows the relationship between earning per share and market value of shares. It can be calculated as:

Earning Yield Ratio = Earnings Per Share/Market price per share * 100.

(iv) MARKET VALUE TO BOOK VALUE RATIO: It is the relationship between market value per share of a firm and its book value per share. Book value per share indicates the net worth per equity share and the ratio of market value to book value may be used to analyze the stock market position of the share.

Market Value to Book Value Ratio= Market price per equity share/Book Value per share Book Value per Share = Equity share capital + Reserves & surpluses – Accumulated losses/Total number of equity shares.

Example:

A company’s equity shares are being traded in the market at Rs. 52 per share with a price-earnings ratio of 4. The company’s dividend payout is 60%. It has 2,00,00 equity shares of Rs 10 each and no preferences shares. Book Value per share is Rs 50. Calculate

(i) Earnings Per Share

(ii) Net Income

(iii) Dividend yield Ratio

(iv) Return on Equity

Solution:

(i) Earnings Per Share (EPS):

Price Earnings Ratio= Market price per equity share/Earnings per share 4 = 52/ Earnings per share

4*EPS = 52 EPS = Rs.13

(ii) Net Income = EPS * No. of Shares

Net Income = 13* 2,00,00 = Rs.2,60,000

(iii) Dividend Yield Ratio:

Dividend Yield Ratio = Dividend per share/Market price per share Dividend per share= Dividend paid to shareholders/ Number of equity shares

= 2,60,000 * 60/100

20,000

=Rs 7.8

Dividend Yield Ratio = 7.8/52*100 = 15%

(iv) Return on Equity

Return on Equity = Net Profit after tax – Preference dividend/Equity share capital*100

2,60,000/(20000*52)*100 = 25%

C. ANALYSIS OF CAPITAL STRUCTURE OR LEVERAGE RATIOS:

The term Capital Structure’ refers to the relationship between various long-term forms of financing such as debentures (generally called as acknowledgment of debt), preference share capital and equity share capital including reserves. Financing the firm’s assets is a very crucial problem in every business and as a general rule there should be a proper mix of debt and equity capital in financing the firm’s assets. Leverage or capital structure ratios are calculated to test the long-term financial position of a firm. In order to analyze the capital structure of the firm these ratios are used:

Leverage may be classified as follows:

(i) Financial Leverage

(ii) Operating Leverage

(iii) Composite Leverage

(i) Financial leverage: This ratio is also considered as ‘Trading on Equity’. The use of a long-term fixed interest bearing debt and preference share capital along the equity share capital is known as financial leverage.

Financial leverage can be calculated as follows: EBIT/EBT

(ii) Operating Ratio: This ratio is calculated by dividing Contribution by EBIT Operating Ratio = Contribution/EBIT

(iii) Combined Leverage = It is the combination of financial leverage and operating leverage.

This statement should be considered while applying leverage ratios:

Add/Less	Particulars	Amount
	Sales	Xx
Less	Variable Cost	Xx
	Contribution	XX
Less	Fixed Cost	Xx
	EBIT	XX
Less	Interest	Xx
	EBT	XX
Less	Tax	Xx
	EAT	XX

EBIT – Earning before interest and tax

EBT – Earning before tax

EAT – Earning after tax (net earnings available to shareholders)

Example:

Calculate Operating Ratio, Financial Ratio and Combined Ratio from the following extracts:

Sales (10000 units @ Rs10)

Variable Cost @ 6 per unit

Fixed Cost = 50,00

Interest = 5000

Tax = 50%

Solution:

This statement should be considered while applying leverage ratios:

PARTICULARS	AMOUNT
Sales	1,00,000
(Less) Variable Cost	(60000)
Contribution	40000
Fixed Cost	5000
EBIT	35000
Interest	5000
EBT	30000
Tax	15000
EAT	15000

(i) Operating Leverage = Contribution/EBIT Operating Leverage = 40000/35000 = 1.14

(ii) Financial leverage = EBIT/EBT Financial leverage = 35000/30000 Financial leverage = 1.17

(iii) Combined Leverage = Operating leverage *Financial leverage Combined Leverage = 1.14 * 1.17 = 1.338

(b) RATIO OF FIXED ASSETS TO FUNDED DEBT: This ratio measures the relationship between the fixed assets and the funded debt (it includes various sources of debt) and is a very useful to the long-term creditors.

Ratio of fixed assets to funded debt = Fixed Assets/ Funded Debt

(c) RATIO OF RESERVES TO EQUITY CAPITAL: The ratio of current liabilities to proprietors’ funds establishes the relationship between current liabilities and the proprietor’s funds and indicates the amount of long term funds raised by the proprietors as against short term borrowings.

(d) RATIO OF RESERVES TO EQUITY CAPITAL: This ratio establishes the relationship between Reserves and Equity Share Capital (The holders of this share are considered as real owners of the company as they have voting right). This ratio indicates that how much profits are generally retained by the firm for future growth. Higher the ratio, generally, better is the position of firm.

(e) DU-PONT CONTROL CHART

This system of management control designed by an American company named Du-Pont Company is popularly known as DU-Pont Control Chart and this system use the inter-relationship to provide charts for managerial attention. The standard ratios of the company are compared to presents ratios and changes in performance are judged.

The chart is based on two elements, Net profit (related to operating expenses) and Capital employed (consists of current assets and net fixed assets)

This ratio is calculated as follows: Profit Margin/Capital Employed* 100

The efficiency of a concern depends upon the working operations of the concern. The return on investments becomes a yardstick to measure efficiency because return influences various operations. The profit margin will show the efficiency with which assets of the business have been used. The efficiency can be improved either by a better relationship between sales and costs or through more effective use of available capital. The profitability can be increased by controlling costs or increasing sales. The investments turnover can be raised by having a control over investments in fixed assets and working capital without adversely affecting sales. The sales may also be increased with the use of same capital and management is able to pinpoint weak spots and take corrective measures. The performance can be better judged by having inter-firm comparison, where ratios of one firm can be compared with the ratio of other firm. The ratios of return on investment, assets turnover and profit margins of comparable companies can be calculated and these can be used as standards of performance.

SUMMARY:

Shareholders are the real owners of the company as they have a voting right and they are interested in real sense in the earnings distributed and paid to them as dividend, this is the reasons why companies calculate various yield ratios like earning and dividend yields ratios. Dividend payout-out ratio is calculated to find the extent to which earnings per share have been retained in the business. All the dividend related ratios are important ratio because ploughing back of profits enables a company to grow and pay more dividends in future. The various dividend related decisions depends upon the profit earning capacity of the firm which is further depends upon the policies frame by the company for financing fixed assets as it is very crucial problem and there should be proper mix of debt and equity. Leverage ratios are calculated to test the long term financial position of a firm which helps the company to frame various policies.

you can view video on Long term Financial Analysis and capital Structure Ratios

Few Suggested Readings:

Gupta, K. Shashi (2004), “Accounting for Managers”. New Delhi- 110 002: Kalyani Publishers.
Gupta, K.Shashi (2013), “Management Control Techniques”. Ludhiana- 141008: Kalyani Publishers
Jaiswal. Pawan & Singh. P Nidhi (2007) “Business Finance” Goel Printers Allahabad.
Narayanaswamy, R,(2005) “Financial Accounting”. Prentice-Hall of India Private Limited, New Delhi.
Sahni, N.K & Gupta Meenu (2011), Financial Management. New Delhi- 110 002: Kalyani Publishers.

Points to Ponder:

1. Long-term solvency ratios indicate a firm’s ability to meet the fixed interest and costs and repayments schedules associated with its long term borrowings.

2. The Debt financing used in a business can be measure with the help of debt equity ratio. The proportionate claims of owners and the outsiders against the firm’s assets can be indicated with the help of this ratio.

3. This ratio is also known as shareholders ratio and proprietor ratio or net worth to total assets ratio. This ratio establishes the relationship between shareholders’ fund to total assets of the firm.

4. Preference shareholders are entitled to receive fixed rate of dividend, whereas equity shareholder gets the dividend after payment to preference shareholder.

The term Capital Structure’ refers to the relationship between various long-term forms of financing.
The return on investments becomes a yardstick to measure efficiency because return influences various operations.
The system of management control designed by an American company use the inter-relationship to provide charts for managerial attention.