The second category of-financial ratio is leverage or capital structure ratios. The long-term creditors would judge the soundness of a firm on the basis of the long-term financial strength measured in terms of its ability to pay the interest regularly as well as repay the installment of the principal on due dates or in one lump sum at the time of maturity. The long-term solvency of a firm can be examined by using leverage or capital structure ratios. The leverage or capital structure ratios may be defined as financial ratios which throw light on the long-term solvency of a firm as reflected in its ability to assure the long-term creditors with regard to (i) periodic payment of interest during the period of the loan and (ii) repayment of principal on maturity or in predetermined installments at due dates.
There are, thus, two aspects of the long-term solvency of a firm: (i) ability to repay the principal when due, and (ii) regular payment of the interest. Accordingly, there are two different, but mutually dependent and interrelated, types of leverage ratios. First, ratios, which are based on the relationship between, borrowed funds and owner‘s capital. These ratios are computed from the balance sheet and have many variations such as (a) debt-equity ratio, (b) debtassets ratio, (c) equity-assets ratio, and so on. The second type of capital, structure ratios, popularly called coverage ratios, are calculated from the profit and loss account. Included in this category are (a) interest coverage ratio, ( b) dividend coverage ratio, (c) total fixed charges coverage ratio, (d) cash flow coverage ratio, and (e) debt services-coverage ratio.
The relationship between borrowed fund and owner‘s capital is a popular measure of the long-term financial solvency of a firm. This relationship is shown by the debt-equity ratios. This ratio reflects the relative claims of creditors and shareholders against the assets of the firm. Alternatively, this ratio indicates the relative proportions of debt and equity in financing the assets of a firm. The relationship between outsiders, claims and owner‘s capital can be shown in different ways and, accordingly, there are many variants of the debt-equity (D/E) ratio.
Debt to Total Capital Ratio
The relationship between creditors‘ funds and owner‘s capital can also be expressed in terms of another leverage ratio. This is the debt to total capital ratio. Here, the outside liabilities are related to the total capitalization of the firm and not merely to the shareholder‘s equity. Essentially, this type of capital structure ratio is a variant of the D/E ratio described above. It can be calculated in different ways.
One approach is to relate the long-term debt to the permanent capital of the firm. Included in the permanent capital is shareholders‘ equity as well as long-term debt. Thus,
Debt to total capital ratio = Long – term debt/Permanent capital
Another approach to calculating the debt to capital ratio is to relate the total debt to the total assets of the firm. The total debt of the firm comprises long-term debt plus current liabilities. The total assets consist of permanent capital plus current liabilities. Thus,
Debt to total assets capital ratio
= Total debt/Total assets
= Total debt/Permanent capital + Current liabilities
Still another variant of the D/E ratio is to relate the owner‘s/ proprietor‘s funds with total assets. This is called the proprietary ratio. The ratio indicates the proportion of total assets financed by owners. symbolically it is equal to:
Proprietor‘s funds/Total assets
Finally, it may also be of some interest to know the relationship between equity funds (also referred to as net worth) and fixed income bearing funds (preference shares, debentures and other borrowed funds). This ratio, called the capital gearing ratio, is useful when the objective is to show the effect of the use of fixed interest/dividend source of funds on the earnings available to the equity shareholders.
The second category of leverage ratios is coverage ratios. These ratios are computed from information available in the profit and loss account. For a normal firm, in the ordinary course of business, the claims of creditors are not met out of the sale proceeds of the permanent assets of the firm. The obligations of a firm are normally met out of the earnings or operating profits.
These claims consist of (i) interest on loans, (ii) preference dividend, and (iii) amortization of principal or repayment of the installment of loans or redemption of preference capital on maturity. The soundness of a firm, from the viewpoint of long term creditors, lies in its ability to service their claims. This ability is indicated by the coverage ratios. The coverage ratios measure the relationship between what is normally available from operations of the firms and the claims of the outsiders. The important coverage ratios are: (i) interest coverage, (ii) dividend coverage, (iii) total coverage, (iv) total cash flow coverage, and (v) debt service coverage ratio.