Capital Structure Ratios

Capital structure ratios are also called as leverage ratios. These ratios focus on the long term solvency of the firm. The long term solvency of the firm always reflected in its ability to meet its long term commitments such as payment of interest periodically without fail, repayment of principal as and when they become due. The below are the most commonly used capital structure ratios.

Debt-Equity Ratio

It is the ratio between outsider’s funds (Debt) and insider’s funds (Equity). It is a measure of solvency. This ratio is used to measure the firm’s obligations to creditors in relation to the owners’ funds. The standard ratio is 1:1. This means for every rupee of debt, there should be one rupee worth internal funds. A high D/E ratio implies that the creditors’ stake is more as compared to that of owners.

Debt-Equity Ratio = Long term loans / Shareholders’ Funds

Debt = Debentures + bonds + mortgage loan + other long term loans.
Equity = Equity share capital + preference share capital + capital reserve + revenue reserve + sinking fund + contingent reserve – artificial assets.
Note: Artificial assets = preliminary expenses + deferred revenue expenses + discount on issue of shares/debentures + profit and loss A/C debit balance + underwriting commission.

Example 1: Calculate Debt-Equity ratio from the following data.

Debentures Rs. 400000, Long term loans Rs. 200000, Preference share capital Rs. 100000, Equity share capital Rs. 150000, General reserve Rs. 250000, Profit & Loss account Rs. 100000.

Solution:

Debt = 400000 + 200000 = 600000

Equity = 100000 + 150000 + 250000 + 100000 = 600000

Debt-Equity Ratio = 600000 / 600000 = 1:1

Interest Coverage Ratio

This ratio judges the firm’s capacity to pay the interest on debt it borrows. The higher the ratio, the better it is. A higher ratio implies that the company has no problems in paying interest.

EBIT = Earnings Before Interest and Tax
Interest = Fixed interest on long term loans

Example: EBIT of a company is Rs. 560000. Its fixed commitments include payment of 10 percent on 7000 debentures of Rs. 100 each. It is subject to tax of 30 percent per annum. Calculate interest coverage ratio.

Solution:

Debentures Amount = 7000 debentures x Rs. 100 each = Rs. 700000
Fixed interest charges on debentures = 700000 x 10/100 = 70000

Interest Coverage Ratio = 560000 / 70000 = 8 times

Proprietor’s Funds to Total Assets Ratio

Proprietors’ Funds = Equity share capital + Preference share capital + General reserve + Employee Provident Fund + profit and loss account.
Total Assets = Tangible assets and Current assets

Example 1: From the Balance Sheet of XYZ Co. Ltd., calculate liquidity ratios.

Solution:

Proprietors’ Funds = 100 + 150 + 250 + 100 = 600
Total assets = 225 + 250 + 100 + 250 + 125 + 250 + 125 + 50 + 125 = 1500
Proprietors’ Funds to Total Assets Ratio = 600 / 1500 = 40%