Ratio analysis of Capital Structure/leverage ratios of a firm

(This article explains the method of computation and the purposes of capital structure ratios viz. Current ratio, Quick ratio/Acid test ratio, Debt Equity Ratio, Solvency Ratio, Proprietary or Equity asset ratio, Fixed assets to tangible net worth plus term debt, Current debt to tangible net worth ratio, Inventory to net working capital ratio, Current debt to inventory ratio, Capital Gearing Ratio)

The Capital Structure/leverage ratios of a company are financial ratios which measure the long term stability and structure of a company. These ratios are known as structural ratios which indicate how a business entity finances its overall operations and growth using different sources of funds.

The method of computation and the purposes of each of above mentioned ratios is given below.

Current Ratio:

This ratio indicates credit strength of a business by indicating how much of current assets are available for meeting each rupee of liability. Therefore, current ratio measures the solvency and adequacy of working capital in a business. It also gives the fair idea of over trading. Any rise in the current ratio shows improved credit strength and fall indicates deteriorating credit strength.  Although, the higher ratio may be good from the point of view of creditors; in the long run very high current ratio may also affect the profitability of the firm.

The current ratio is obtained by the division of total current assets by total current liabilities. The formula for measuring current ratio is;

Total Current Assets ÷Total Current Liabilities

Desirable Current Ratio is 2:1.Generally, acceptable minimum current ratio in India is 1.33; any persisting trend of less than 1 over a period is a sure indicator of sickness.

Quick ratio/Acid test:

The objective of Quick ratio/Acid test is to know the level of liquidity position to pay off all current liabilities including Bank Liabilities. The ratio indicates the extent to which current liabilities could be met without relying upon the sale of stock, which means the size of the liquid assets that can be readily converted into cash in relation to the total liability.

Cash, marketable securities and account receivables to be divided by current liabilities to obtain Quick ratio. The formula for calculation of quick ratio is;

Total current assets-inventory/Total current liabilities

There is another method of computing Quick Ratio wherein

(Cash+ Receivable + RBI approved investment) ÷ (Current Liabilities less Cash Credit Liabilities in banks against inventory)

The value of inventory and liabilities against inventories is excluded here because of difficulties to sell and realize the full value of inventory at short notice during liquidity crisis. Quick Ratio should be equal to 1 or more than 1

Debt Equity Ratio (DER) or Total debt to tangible net worth ratio :

This Ratio indicates the relative financial stakes of the creditors compared to owners’ stake in the business. This ratio also measures the long-term solvency and ability of the concern to meet long-term liabilities. The ratio is obtained by dividing long and short term debts by tangible net worth. The formula for debt equity ratio is;

DER = (Total of Long Term Liabilities and Short term Liabilities) ÷ Tangible Net worth

Debt Equity Ratio is aid to be satisfactory, if it is 2:1 or above. In India, acceptable DER is normally 3:1 for SSI units and 2:1 for MLI units and trading concerns. Tolerable ratio in exceptional cases is 4:1.If ratio position increases that may indicate that the business is being exposed to hazards of greater and greater borrowings and the business may slip into financial problems, especially during unexpected contingencies like   sudden downward sales, customers’ preferences to change in style etc.

Some financial institutions also verify Funded Debt ÷ Equity Ratio (FDER) for financing new projects i.e.

FDER= Long term debts÷ Tangible Net Worth

Acceptable FDER for SSI is 2:1, for large and medium Industries it is 1.5:1

Solvency Ratio:

If tangible assets are more than a firm’s term & current liabilities, the unit can be called as solvent. The formula for solvency ratio is;

Total Tangible assets ÷ Total outside liability

Solvency ratio is computed by dividing total tangible assets by total outside liabilities.

Proprietary or Equity asset ratio:

The ratio indicates the shareholders’ stake in asset holding and it reflects the degree of safety or margin of protection available to the creditors. Proprietary or Equity asset ratio is computed by dividing “total share-holders’ funds” by “total assets” The formula for calculating Proprietary or Equity asset ratio is;

Total Capital ÷Total Assets

Increase in ‘Equity asset’ ratio indicates decrease of debts which is a sign of increasing financial strength and of a good management.

Fixed assets to tangible net worth plus term debt:

This ratio is computed by Net fixed assets divided by net worth plus term debt. The ratio shows the long term stability relationship of own and borrowed funds. The ratio should not exceed 1:1 for a manufacturing concern and 0.75:1 for wholesaler. The increase in ratio is undesirable. If the ratio increases, the margin of operating funds become too narrow, and may expose the enterprise to hazards of debt pressure and insufficiency of working capital. The formula for fixed assets to tangible net worth plus term debt is;

     Fixed Assets ÷ (Tangible net worth + Term Liabilities)

Current debt to tangible net worth ratio:

Current debt to tangible net worth ratio measures long term stability relationship of own and borrowed funds. It is computed by dividing current liabilities by tangible net worth. Current debt to tangible net worth ratio is calculated by

Current Liabilities÷ tangible net worth

Increase in ratio indicates the increase in the creditors which may result into debt pressure due to insufficiency of own capital.

Inventory to net working capital ratio:

Inventory is divided by net working capital to compute Inventory to net working capital. If inventory position is too high, due to unsold inventory, the firm may face difficulty in meeting current obligations.

The formula for calculating Inventory to net working capital ratio is;

Inventory ÷ Net working capital

The thumb rule is that inventory should not exceed 80% of the working capital. 

Current debt to inventory ratio:  Current Liabilities÷ inventory

Current debt to inventory ratio measures the relation between current liabilities and inventories.  The steady increase in the ratio means increase of current liabilities and decrease in inventory which is not a favorable trend. The formula for calculating ‘Current debt to inventory ratio’ is:

Current Liabilities÷ inventory

The generally acceptable ‘Current debt to inventory ratio’ is less than 0.75

Capital Gearing Ratio:  

Gearing is utilizing external source of funds (borrowings) to increase the yield on equity. This is known as financial leverage. A company is called highly geared when its interest/fixed charge bearing funds are exorbitantly high compared to net worth. The formula for Capital Gearing Ratio is:  

Fixed charge bearing long term funds÷ Total long term liabilities (Term Liabilities +Net worth)

The desirable ratio is 3:1, satisfactory ratio is 5:1, and Tolerable is 8:1. A high ratio of gearing is a risky, particularly when the firm is unable to earn adequate profits in a given year, which may push the company into debt trap, due to insufficiency of own capital. Wherein,

Capital Employed = Equity share capital, Reserve and Surplus, Debentures and long-term Loans

Or Capital Employed = Total Assets – Current Liability

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