Navreet kaur , Section (B), Roll No. 83
Gagandeep, Section (A)
Nimish batra, Section (C), Roll No. 146
Ø INTRODUCTION
Debt-to-assets ratio or simply debt ratio is the ratio of total liabilities of a business to its total assets. It is a solvency ratio and it measures the portion of the assets of a business which are financed through debt.
Formula
The formula to calculate the debt ratio is:
| Debt Ratio = | Total Liabilities |
| Total Assets |
Total liabilities include both the current and non-current liabilities.
Analysis
Debt ratio ranges from 0.00 to 1.00. Lower value of debt ratio is favorable and a higher value indicates that higher portion of company's assets are claimed by it creditors which means higher risk in operation since the business would find it difficult to obtain loans for new projects. Debt ratio of 0.5 means that half of the company's assets are financed through debts.
Examples
In order to calculate debt ratio from the balance sheet, divide total liabilities by total assets, for example:
Example 1: Total liabilities of a company are $267,330 and total assets are $680,400. Calculate debt ratio.
Solution
Debt ratio = $267,330/$680,400 = 0.393 or 39.3%
Example 2: Current liabilities are $34,600; Non-current liabilities are $200,000; and Total assets are $504,100. Calculate debt ratio.
Solution
Since total liabilities are equal to sum of current and non-current liabilities therefore,
Debt Ratio = ($34,600 + $200,000) / $504,100 = 0.465 or 46.5%.
Debt to Equity Ratio:
Definition:
Debt-to-Equity ratio indicates the relationship between the external equities or outsiders funds and the internal equities or shareholders funds.
It is also known as external internal equity ratio. It is determined to ascertain soundness of the long term financial policies of the company.
§ Formula of Debt to Equity Ratio:
Following formula is used to calculate debt to equity ratio -
Ø Debt Equity Ratio = External Equities / Internal Equities
Or
[Outsiders funds / Shareholders funds]
Components:
The two basic components of debt to equity ratio are outsider’s funds -
I. External equities and share holders’ funds.
II. Internal equities.
The outsider’s funds include all debts / liabilities to outsiders, whether long term or short term or whether in the form of debentures, bonds, mortgages or bills. The shareholders funds consist of equity share capital, preference share capital, capital reserves, revenue reserves, and reserves representing accumulated profits and surpluses like reserves for contingencies, sinking funds, etc. The accumulated losses and deferred expenses, if any, should be deducted from the total to find out shareholder's funds
Some writers are of the view that current liabilities do not reflect long term commitments and they should be excluded from outsider's funds. There are some other writers who suggest that current liabilities should also be included in the outsider's funds to calculate debt equity ratio for the reason that like long term borrowings, current liabilities also represents firm's obligations to outsiders and they are an important determinant of risk. However, we advise that to calculate debt equity ratio current liabilities should be included in outsider's funds. The ratio calculated on the basis outsider's funds excluding liabilities may be termed as ratio of long-term debt to share holders funds.
Example:
From the following figures calculate debt to equity ratio:
| Equity share capital | 1,100,000 |
Required: Calculate debt to equity ratio.
Calculation:
External Equities / Internal Equities
= 1,200,000 / 18,000,000
= 0.66 or 4: 6
Ø DISSCUSSIONS
Significance of Debt to Equity Ratio:
Debt to equity ratio indicates the proportionate claims of owners and the outsiders against the firm’s assets. The purpose is to get an idea of the cushion available to outsiders on the liquidation of the firm. However, the interpretation of the ratio depends upon the financial and business policy of the company. The owners want to do the business with maximum of outsider's funds in order to take lesser risk of their investment and to increase their earnings (per share) by paying a lower fixed rate of interest to outsiders. The outsider’s creditors) on the other hand, want that shareholders (owners) should invest and risk their share of proportionate investments. A ratio of 1:1 is usually considered to be satisfactory ratio although there cannot be rule of thumb or standard norm for all types of businesses. Theoretically if the owner’s interests are greater than that of creditors, the financial position is highly solvent. In analysis of the long-term financial position it enjoys the same importance as the current ratio in the analysis of the short-term financial position.
The Importance of Cash Flow to Debt Ratio
There are a lot of complicated things in the trading industry, and everyone should definitely agree on that fact. There are a lot of things that a person should know when he decides to engage in the trading industry. We all know that being in this industry has a lot of complicated terms and most importantly there is no room for mistakes, since it may bring unwanted drastic situations.
The trading industry has a lot of important components that needs to followed and implemented. one of which is the cash flow. Even though this term is simple, yet there are a lot of things that cash flow can do to help you achieve a successful trading system.
For you to fully understand the importance of cash flow there are some important considerations that you need to know about cash flow especially on debts ratios. The debt ratios that you need to look at is the aspect of a company’s finances that is broadly called coverage ratios. The cash flow to debt ratio can be important because when the debt of a company has no chance of being fixed, you will always have the option to not invest in that company.
But some capital-intensive industries may have a lower cash flow to debt ratio than other industries. However, you will know the numbers to calculate the cash flow to debt ratio of a company in the company’s financial statements. Certainly, you would want to be careful with those companies that have a low cash flow to debt ratios. Especially, in these difficult economic times the cash flow can suffer, but the debt doesn’t go down. The larger the ratio of a company is; the better a company can weather a rough economic conditions. So when determining those companies that you want to buy shares in, a good look at their ability to pay t heir current debts is an important thing to look at.
Ø CONCLUSION
These ratios give users a general idea of the company's overall debt load as well as its mix of equity and debt. Debt ratios can be used to determine the overall level of financial risk a company and its shareholders face. In general, the greater the amount of debt held by a company the greater the financial risk of bankruptcy.
The ratios covered in this section include the debt ratio, which is gives a general idea of a company's financial leverage as does the debt-to-equity ratio. The capitalization ratio details the mix of debt and equity while the interest coverage ratio and the cash flow to debt ratio show how well a company can meet its obligations.
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