Solvency ratio

Solvency ratio
1. Debt Equity ratio
	Article-79
We have discussed the liquidity ratios, Current ratio and quick ratio. Liquidity ratios bring about the ability of the organizations to meet their short-term obligations. Whereas solvency ratios indicate the organization’s ability to honour the long term liabilities. By finding out these ratios, one can understand that an establishment has sufficient long-term funds to meet its long-term obligations. Mainly the long-term creditors are interested in solvency ratios. These ratios will help them to judge the soundness of the company based on long-term financial strength. That is, the company’s ability to pay interest regularly and make repayment of principal correctly.
Debt Equity ratio shows the relationship between borrowed funds and owners’ funds. Otherwise, we can say, it is the relationship between external funds (debt) and internal funds (equity). This relationship is a popular measure of the long-term financial solvency. It can be interpreted in many ways such as: ·         This ratio reflects the relative claims of creditors and shareholders on the assets of the firm/Company. ·         It shows the extent of the firm’s dependence on external liabilities or external source of funds. ·         It indicates the relative proportions of debt and equity, in financing the assets of the Company. ·         It is the relationship between outsiders’ claim and owner’s capital.
For calculating this ratio, the required components are external liabilities and owner’s equity or net worth. v  External liabilities include both long-term and short-term liabilities. v  The components of owner’s equity are Ø  Paid up capital Ø  Reserves and surplus Ø  Undistributed profits It excludes past-accumulated losses and deferred expenditure.
Commonly two approaches are there to work out this ratio viz. debt equity ratio and total debt equity ratio.        debt equity ratio=Long term Debt/Owners’ equity; Total debt equity ratio= Total debt/ Owners’ equity.
Significance:
Suggested standard ratio is 2:1. However, what ratio is ideal will depends upon the nature of the business and the prevailing economic conditions. During business prosperity, high ratio is favourable. Higher the ratio, greater would be the risk as the firm has to pay interest irrespective of profits.
Interpretation:
·         A high debt equity ratio shows a large share of financing by the creditors relatively to owners. This implies creditors have larger claim against the assets of the Company.
·         This ratio indicates a margin of safety to creditors. A Debt equity ratio 1:2 implies that for every rupee of outside liability, the Company has two rupees of owners’ capital.
·         A high debt equity ratio would lead into inflexibility in the operations of the Company as creditors would interfere in the management and exert pressure. Moreover, the Company will have to face serious difficulties in rising funds in future.
To conclude, both high and low Debt Equity ratios are not desirable. It should strike a proper balance between debt and equity. This ratio depends upon various factors such as type of business, nature of industry, degree of risk involved etc. Stable income industries can afford to have a higher ratio (electric Company).