Long-term creditors judge the financial soundness of the firm on two criteria :
(a) ability to pay the due interest regularly; and
(b) repay the principal amount owed as per terms of the loan;viz. as one lumpsum at maturity or by instalments on the respective due dates. Leverage,or capital-structure, ratios are employed for this purpose. There are two types of "leverage" ratios for these purposes, these being mutually dependent and inter-related. As is only inferable, the P & L A/c which contains information on the business income and the appropriations, will be the essential basis for the leverage ratios for the periodic payments; and the information in the BS goes largely to generate the leverage ratios relating the borrowed funds to owners' capital, indicative of the firm's ability to repay the principal amount of the loans, as lumpsum or as instalments. Considering the long-term liabilities of debt and equity and the long-term assets, reflected(a) debt-equity ratio;
(b)debt-assets ratio; and
(c) equity-assets ratio.
(Note : "Debt" is generally in the numerator and "Assets" is generally in the denominator.)
Preference shares and debts carry "fixed" "returns", i.e. the periodical earnings out of them is at a pre-determined percentage of the amount (of face-value). This percentage being "fixed", these are called "fixed return" capital. Earnings on equity are dependent on the residual incorne after due deductions out of the total income and are further dependent on the dividend policy adopted from time-to-time. Thus, equity capital is the "variable return capital". Considering these facts, the essential "coverage,' ratios calculated from theP&LNcare:
(a) interest coverage ratios;
(b) dividend coverage raiios; and
(c) (total) fixed charges coverage ratios.
These and a few other ratios of the same categories are discussed in what iollows :
Debt-Equity Ratios (D/E)
The relationship between borrowed funds and owners' capital is a very popular measure of the long-term financial solvency of a firm. (Whereas "liquidity" is used when discussing "short-term" considerations, "solvency" is used when discussing "long-term" considerations.) The ratio reflects the relative claims of creditors and shareholders against the assets of the firm. There are several variants of representing this "relative claims" situation.
D/E=Long-term debt/Shareholders' equity
considers only the long-term debt and excludes current liabilities as part of "debt" and takes both ordinary as well as preference capital and past accumulated profits shareholders' equity with specifically excluding (past) accumulated losses [i.e. debit balance, whenever it so occurs, of the P & L N c ] and discount on issue of shares and deferred expenditures, if any. Shareholders' equity so defined is what is considered as "net worth" of the firm. This ratio, thus computed, is called "Debt-to-Net Worth" ratio.Shareholders' equity is used in the sense of "net worth" in Debt-Equity ratio, Debt to Total Capital ratio and Capital Gearing ratio.If Current liabilities are also clubbed with long-term debts, the resultant value is called "total debt", and we have the variant of the DIE ratio as
(a) ability to pay the due interest regularly; and
(b) repay the principal amount owed as per terms of the loan;viz. as one lumpsum at maturity or by instalments on the respective due dates. Leverage,or capital-structure, ratios are employed for this purpose. There are two types of "leverage" ratios for these purposes, these being mutually dependent and inter-related. As is only inferable, the P & L A/c which contains information on the business income and the appropriations, will be the essential basis for the leverage ratios for the periodic payments; and the information in the BS goes largely to generate the leverage ratios relating the borrowed funds to owners' capital, indicative of the firm's ability to repay the principal amount of the loans, as lumpsum or as instalments. Considering the long-term liabilities of debt and equity and the long-term assets, reflected(a) debt-equity ratio;
(b)debt-assets ratio; and
(c) equity-assets ratio.
(Note : "Debt" is generally in the numerator and "Assets" is generally in the denominator.)
Preference shares and debts carry "fixed" "returns", i.e. the periodical earnings out of them is at a pre-determined percentage of the amount (of face-value). This percentage being "fixed", these are called "fixed return" capital. Earnings on equity are dependent on the residual incorne after due deductions out of the total income and are further dependent on the dividend policy adopted from time-to-time. Thus, equity capital is the "variable return capital". Considering these facts, the essential "coverage,' ratios calculated from theP&LNcare:
(a) interest coverage ratios;
(b) dividend coverage raiios; and
(c) (total) fixed charges coverage ratios.
These and a few other ratios of the same categories are discussed in what iollows :
Debt-Equity Ratios (D/E)
The relationship between borrowed funds and owners' capital is a very popular measure of the long-term financial solvency of a firm. (Whereas "liquidity" is used when discussing "short-term" considerations, "solvency" is used when discussing "long-term" considerations.) The ratio reflects the relative claims of creditors and shareholders against the assets of the firm. There are several variants of representing this "relative claims" situation.
D/E=Long-term debt/Shareholders' equity
considers only the long-term debt and excludes current liabilities as part of "debt" and takes both ordinary as well as preference capital and past accumulated profits shareholders' equity with specifically excluding (past) accumulated losses [i.e. debit balance, whenever it so occurs, of the P & L N c ] and discount on issue of shares and deferred expenditures, if any. Shareholders' equity so defined is what is considered as "net worth" of the firm. This ratio, thus computed, is called "Debt-to-Net Worth" ratio.Shareholders' equity is used in the sense of "net worth" in Debt-Equity ratio, Debt to Total Capital ratio and Capital Gearing ratio.If Current liabilities are also clubbed with long-term debts, the resultant value is called "total debt", and we have the variant of the DIE ratio as
D/E= Total debt (inclusive of CL)/Shareholders' equity
which may be called as "Total Debt-to-Equity" ratio. The "rationale" of including CL includes :
(a) Quite a part of CL is continuously in use in the business, as though a "long-term" source (more of it under Unit 20);
(b) CL components like bank credit are generally renewed year after year;
(c) Like long-tenn creditors, CL too have a prior right on the f m ' s assets;
(d) Short-term creditors too work as a pressure-group on the firm's management.
If the D/E ratio is high, it implies that owners are putting in less money of their own. If there is failure in the business, the creditors lose heavily. In such a situation, creditors exercise pressure on, and interfere in, management; also further loans become more and more impossible. However, if business is successful, the returns to the shareholders increases substantially, more than proportionately with an increase in the operating profits of the firm. This situation is called "leverage" or "trading on equity".In capital-rich countries (and ambiences) DIE is generally small (of the order of 1 : 3); but in under-developed economics, DIE ratio of 2 : 1 is generally accepted practice, going even upto 3 : 1. When business conditions are stable, and may tend to be on upswing, increased D/E may be acceptable. A new company may have a lower DIE compared to a well established company (one of the reasons being that,the older company's assets would have depreciated more).The other two ratios, viz. debt-to-assets, and equity-to-assets, are implicitly discussed in the next item : "Debt to Total Capital Ratio".
Debt to Total Capital Ratio
The concept of capitalisation should be understood before this ratio can be discussed. It has earlier been mentioned in a previous unit that any expenditure incurred by a business will be either as cost of the period or as an asset to be carried forward to subsequent periods, the latter treatment being called as "Capitalisation" (i.e. treated as an asset). Extending the same concept, capitalisation of a firm will mean the determination of the amount which the firm should have at its disposal, this amount consisting of the amount required for fixed assets and that portion of working capital which the firm must find from its own sources - all of which must have to be met out of long-term funds or by "total debt" as described in under DIE ratio (to be read along with the "rationale").
In this ratio, the outside liabilities (i.e. the debts) are related to the total capitalisation of the firm and not merely to the shareholders' equity (see under DIE ratio). Accordingly, this definition of the capital structure ratio is a variant of the DIE ratio discussed in above.The following are the several alternative definitions in vogue :
Capital Gearing Ratio (CGR)
The relation between shareholders' equity and the fixed-in come-bearing funds (i.e.sum of preference shares, debentures, and other borrowed funds) is called capital gearing ratio.
CGR =Ordinary shares/Fixed return Funds
This ratio has a great bearing on the dividend fund availability (on the lines as discussed under D/E ratio.
Coverage Ratios
The D/E ratios (along with the variants) discussed as above indicate whether adequate safety margin is available to the creditors, or not. The cushion reflected in these ratios is,-clearly, to be invoked at the time of liquidation of the firm. But, in ordinary course of business, the claims of creditors are not met out of sale proceeds of the permanent assets of the firm but out of the earnings or "operating profit" of the firm. Coverage ratios, relevant as they are in such instances, quantify as to what proportion of the claims of outsiders can be . met from funds available follow. As has been mentioned earlier, coverage ratios are computed from information available in P & L A/c. Claims of creditors considered under these ratios consist of
(a) interest on loans,
(b) preference dividend, and
(c) amortisation of principal or repayment of the instalment of loans or redemption of preference capital on maturity.
The relevant coverage ratios indicate the ability of the firm to "service" these claims.
Interest Coverage Ratio (ICR)
This is known also as "times-interest-earned ratio" and as "debt service coverage ratio". Fixed interest on long-term loans is the claim considered in this ratio. The "operating profits", i.e. Earnings Before Interest and Taxes (EBIT) is divided by the "fixed interest charges on loans", simply called "interest".
Interest coverage ratio =EBIT/Interest
Since interest is tax-deductible, tax is calculated after paying interest on long-term loans; accordingly, the numerator considers as to how much larger are the gross operating profits than the interest outgoings due. The ratio then shows how many times the interest charges are covered by the EBIT out of which the interest charges will be paid. As the creditors would view, the larger the ratio, the more assured the payment of interest to creditors; simultaneously, the large ratio would also imply "unused debt capacity" (which is akin to "reserve borrowing power"referred to under SQR in respect of quick (current) assets ("Debt" refemng to "long-term debt") a low ratio, on the other hand, indicates that the firm has resorted to excessive debts and cannot assure payment of interest to the creditors.
Dividend Coverage Ratio (DCR)
Dividend on preference shares at the respectively stated rates of return is what is considered here. This can be paid only after interest on loans (which is a charge on the profit) has been paid to the respective outside claimants and the taxes too have thereafter been paid (or at least provided for). Accordingly, only earnings after taxes can be the base out of which this dividend can be taken as an appropriation.
Therefore.
Dividend Coverage Ratio =EAT/Preference Dividend
Like the interest coverage ratio, this ratio (DCR) indicates the safety margin available to the preference share holders.
Total Coverage Ratio (TCR)
Interest coverage and preference dividend coverage ratios consider the fixed, and repetitive or recurring, obligations of a firm to the respective suppliers of funds (as long-term creditors and preference shares, respectively). The total coverage ratio covers, besides the above two obligations of charge and appropriation,respectively, of profits, other fixed obligations of the firm, viz. lease paymen,ts (LP), and repayment of principal amounts (of the loans). Since (instalments of) repayment of principal amount (Inst. Pr.) is not tax-deductible, like preference dividend (PD) too is not, the sum of these two is divided by (1 - t ) , where t is the tax rate (in fraction) applicable to the firm.
Therefore.
where LP stands for lease payment, I for interest on loans, PD for preference dividend anrl Tnst. Pr for instalment or renavment o f nrincioal (of the loans).t
Total Cash Flow Coverage Ratio
The three coverage ratios discussed above (ICR, DCR and TCR) have related the firm's ability to meet its financial obligations (indicated respectively in each ratio) to the firm's earnings. However, in matter of fact, these payments have to be met out of cash (and bank balances) available with the firm. [Other components of CA as seen under the Illustration (following SQR) are not to be depended upon for meeting these obligations.] In this context, it is also to be recalled that
(i) depreciation is an item of cost which does not involve outflow of cash; and so
(ii) cash flow is defined as post-tax operating profit + depreciation generated by operations.This ratio is, therefore, conceived as a modification of the Total Coverage Ratio by adapting it to the cash flow concept, and, other non-cash expenses also are considered along with depreciation.
Total cash flow coverage ratio
which may be called as "Total Debt-to-Equity" ratio. The "rationale" of including CL includes :
(a) Quite a part of CL is continuously in use in the business, as though a "long-term" source (more of it under Unit 20);
(b) CL components like bank credit are generally renewed year after year;
(c) Like long-tenn creditors, CL too have a prior right on the f m ' s assets;
(d) Short-term creditors too work as a pressure-group on the firm's management.
If the D/E ratio is high, it implies that owners are putting in less money of their own. If there is failure in the business, the creditors lose heavily. In such a situation, creditors exercise pressure on, and interfere in, management; also further loans become more and more impossible. However, if business is successful, the returns to the shareholders increases substantially, more than proportionately with an increase in the operating profits of the firm. This situation is called "leverage" or "trading on equity".In capital-rich countries (and ambiences) DIE is generally small (of the order of 1 : 3); but in under-developed economics, DIE ratio of 2 : 1 is generally accepted practice, going even upto 3 : 1. When business conditions are stable, and may tend to be on upswing, increased D/E may be acceptable. A new company may have a lower DIE compared to a well established company (one of the reasons being that,the older company's assets would have depreciated more).The other two ratios, viz. debt-to-assets, and equity-to-assets, are implicitly discussed in the next item : "Debt to Total Capital Ratio".
Debt to Total Capital Ratio
The concept of capitalisation should be understood before this ratio can be discussed. It has earlier been mentioned in a previous unit that any expenditure incurred by a business will be either as cost of the period or as an asset to be carried forward to subsequent periods, the latter treatment being called as "Capitalisation" (i.e. treated as an asset). Extending the same concept, capitalisation of a firm will mean the determination of the amount which the firm should have at its disposal, this amount consisting of the amount required for fixed assets and that portion of working capital which the firm must find from its own sources - all of which must have to be met out of long-term funds or by "total debt" as described in under DIE ratio (to be read along with the "rationale").
In this ratio, the outside liabilities (i.e. the debts) are related to the total capitalisation of the firm and not merely to the shareholders' equity (see under DIE ratio). Accordingly, this definition of the capital structure ratio is a variant of the DIE ratio discussed in above.The following are the several alternative definitions in vogue :
Capital Gearing Ratio (CGR)
The relation between shareholders' equity and the fixed-in come-bearing funds (i.e.sum of preference shares, debentures, and other borrowed funds) is called capital gearing ratio.
CGR =Ordinary shares/Fixed return Funds
This ratio has a great bearing on the dividend fund availability (on the lines as discussed under D/E ratio.
Coverage Ratios
The D/E ratios (along with the variants) discussed as above indicate whether adequate safety margin is available to the creditors, or not. The cushion reflected in these ratios is,-clearly, to be invoked at the time of liquidation of the firm. But, in ordinary course of business, the claims of creditors are not met out of sale proceeds of the permanent assets of the firm but out of the earnings or "operating profit" of the firm. Coverage ratios, relevant as they are in such instances, quantify as to what proportion of the claims of outsiders can be . met from funds available follow. As has been mentioned earlier, coverage ratios are computed from information available in P & L A/c. Claims of creditors considered under these ratios consist of
(a) interest on loans,
(b) preference dividend, and
(c) amortisation of principal or repayment of the instalment of loans or redemption of preference capital on maturity.
The relevant coverage ratios indicate the ability of the firm to "service" these claims.
Interest Coverage Ratio (ICR)
This is known also as "times-interest-earned ratio" and as "debt service coverage ratio". Fixed interest on long-term loans is the claim considered in this ratio. The "operating profits", i.e. Earnings Before Interest and Taxes (EBIT) is divided by the "fixed interest charges on loans", simply called "interest".
Interest coverage ratio =EBIT/Interest
Since interest is tax-deductible, tax is calculated after paying interest on long-term loans; accordingly, the numerator considers as to how much larger are the gross operating profits than the interest outgoings due. The ratio then shows how many times the interest charges are covered by the EBIT out of which the interest charges will be paid. As the creditors would view, the larger the ratio, the more assured the payment of interest to creditors; simultaneously, the large ratio would also imply "unused debt capacity" (which is akin to "reserve borrowing power"referred to under SQR in respect of quick (current) assets ("Debt" refemng to "long-term debt") a low ratio, on the other hand, indicates that the firm has resorted to excessive debts and cannot assure payment of interest to the creditors.
Dividend Coverage Ratio (DCR)
Dividend on preference shares at the respectively stated rates of return is what is considered here. This can be paid only after interest on loans (which is a charge on the profit) has been paid to the respective outside claimants and the taxes too have thereafter been paid (or at least provided for). Accordingly, only earnings after taxes can be the base out of which this dividend can be taken as an appropriation.
Therefore.
Dividend Coverage Ratio =EAT/Preference Dividend
Like the interest coverage ratio, this ratio (DCR) indicates the safety margin available to the preference share holders.
Total Coverage Ratio (TCR)
Interest coverage and preference dividend coverage ratios consider the fixed, and repetitive or recurring, obligations of a firm to the respective suppliers of funds (as long-term creditors and preference shares, respectively). The total coverage ratio covers, besides the above two obligations of charge and appropriation,respectively, of profits, other fixed obligations of the firm, viz. lease paymen,ts (LP), and repayment of principal amounts (of the loans). Since (instalments of) repayment of principal amount (Inst. Pr.) is not tax-deductible, like preference dividend (PD) too is not, the sum of these two is divided by (1 - t ) , where t is the tax rate (in fraction) applicable to the firm.
Therefore.
where LP stands for lease payment, I for interest on loans, PD for preference dividend anrl Tnst. Pr for instalment or renavment o f nrincioal (of the loans).t
Total Cash Flow Coverage Ratio
The three coverage ratios discussed above (ICR, DCR and TCR) have related the firm's ability to meet its financial obligations (indicated respectively in each ratio) to the firm's earnings. However, in matter of fact, these payments have to be met out of cash (and bank balances) available with the firm. [Other components of CA as seen under the Illustration (following SQR) are not to be depended upon for meeting these obligations.] In this context, it is also to be recalled that
(i) depreciation is an item of cost which does not involve outflow of cash; and so
(ii) cash flow is defined as post-tax operating profit + depreciation generated by operations.This ratio is, therefore, conceived as a modification of the Total Coverage Ratio by adapting it to the cash flow concept, and, other non-cash expenses also are considered along with depreciation.
Total cash flow coverage ratio
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