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 that help management form the opinion about financial solvency about business are called “Solvency Ratios”.
Solvency Ratios indicate 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 that has already been explained. Now under this part, only the long-term solvency ratios are dealt with. Some of the important ratios 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 to funds invested by the owners. It is an indication of all external liabilities to the 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 variants of the Debt-Equity Ratio. The term proprietary fund is called Net Worth. This ratio forms the relationship between shareholders’ funds and total assets.
3. Capital Gearing Ratio
This ratio is also called Capitalization or Leverage Ratio. This is one of the Solvency Ratios. The term capital gearing describes the relationship between fixed interest and 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 understand that the business concern will be able to pay its interest periodically.