Classification of Solvency Ratios:

1. Debt-Equity Ratio
2. Debt to Total Funds Ratio
3. Fixed Assets Ratio
4. Proprietary Ratio
5. Interest Coverage Ratio

Meaning, Objective and Method of Calculation:

1. Debt-Equity Ratio: Debt equity ratio shows the relationship between long-term debts and shareholders funds’. It is also known as ‘External-Internal’ equity ratio.




Debt Equity Ratio		Debt
	=
		Equity

Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: This ratio is a measure of owner’s stock in the business. Proprietors are always keen to have more funds from borrowings because:

(i) Their stake in the business is reduced and subsequently their risk too
(ii) Interest on loans or borrowings is a deductible expenditure while computing taxable profits. Dividend on shares is not so allowed by Income Tax Authorities.

The normally acceptable debt-equity ratio is 2:1.

2. Debt to Total Funds Ratio: This ratio gives same indication as the debt-equity ratio as this is a variation of debt-equity ratio. This ratio is also known as solvency ratio. This is a ratio between long-term debt and total long-term funds.




Debt to Total Funds Ratio		Debt
	=
		Total Funds

Where Debt (long term loans) include Debentures, Mortgage Loan, Bank Loan, Public Deposits, Loan from financial institution etc.

Total Funds = Equity + Debt = Capital Employed

Equity (Shareholders’ Funds) = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Objective and Significance: Debt to Total Funds Ratios shows the proportion of long-term funds, which have been raised by way of loans. This ratio measures the long-term financial position and soundness of long-term financial policies. In India debt to total funds ratio of 2:3 or 0.67 is considered satisfactory. A higher proportion is not considered good and treated an indicator of risky long-term financial position of the business. It indicates that the business depends too much upon outsiders’ loans.

3. Fixed Assets Ratio: Fixed Assets Ratio establishes the relationship of Fixed Assets to Long-term Funds.




Fixed Assets Ratio		Long-term Funds
	=
		Net Fixed Assets

Where Long-term Funds = Share Capital (Equity + Preference) + Reserves and Surplus + Long-term Loans – Fictitious Assets

Net Fixed Assets means Fixed Assets at cost less depreciation. It will also include trade investments.

Objective and Significance: This ratio indicates as to what extent fixed assets are financed out of long-term funds. It is well established that fixed assets should be financed only out of long-term funds. This ratio workout the proportion of investment of funds from the point of view of long-term financial soundness. This ratio should be equal to 1. If the ratio is less than 1, it means the firm has adopted the impudent policy of using short-term funds for acquiring fixed assets. On the other hand, a very high ratio would indicate that long-term funds are being used for short-term purposes, i.e. for financing working capital.

4. Proprietary Ratio: Proprietary Ratio establishes the relationship between proprietors’ funds and total tangible assets. This ratio is also termed as ‘Net Worth to Total Assets’ or ‘Equity-Assets Ratio’.




Proprietary Ratio		Proprietors’ Funds
	=
		Total Assets

Where Proprietors’ Funds = Shareholders’ Funds = Share Capital (Equity + Preference) + Reserves and Surplus – Fictitious Assets

Total Assets include only Fixed Assets and Current Assets. Any intangible assets without any market value and fictitious assets are not included.

Objective and Significance: This ratio indicates the general financial position of the business concern. This ratio has a particular importance for the creditors who can ascertain the proportion of shareholder’s funds in the total assets of the business. Higher the ratio, greater the satisfaction for creditors of all types.

5. Interest Coverage Ratio: Interest Coverage Ratio is a ratio between ‘net profit before interest and tax’ and ‘interest on long-term loans’. This ratio is also termed as ‘Debt Service Ratio’.
   
   

   Interest Coverage Ratio		Net Profit before Interest and Tax
   	=
   		Interest on Long-term Loans

   
   Objective and Significance: This ratio expresses the satisfaction to the lenders of the concern whether the business will be able to earn sufficient profits to pay interest on long-term loans. This ratio indicates that how many times the profit covers the interest. It measures the margin of safety for the lenders. The higher the number, more secure the lender is in respect of periodical interest.