M.COM. SEMESTER - II (CBCS)
CORPORATE FINANCE
Q.10. LEVERAGE
RATIOS / CAPITAL STRUCTURE RATIOS
ANS:
The
long-term financial stability of the firm may be considered as dependent upon
its ability to meet all its liabilities, ncluding those not currently payable.
The ratios which are important in measuring the financial leverage of the
company are as follows:
1.
Debt-Equity Ratio
This ratio
indicates the relationship between loan funds and net worth of the company,
which is known as `gearing’. If the proportion of debt to equity is low, a
company is said to be low geared, and vice versa. A debt-equity ratio of 2:1 is
the norm accepted by financial institutions for financing of projects. Higher debt-equity
ratio of 3:1 may be permitted for higher capital intensive industries like
petrochemicals, fertilizers, power etc. The higher the gearing, the higher
volatile the return to the shareholders. The formula is:
Long Term
Debt
Shareholders’
Funds
The use of
debt capital has direct implications for the profit accruing to the ordinary
shareholders and expansion is often financed in this manner with the objective
of increasing the shareholders rate of return. This objective is achieved only
if the rate earned on the additional funds raised exceeds that payable to the
providers of the loan. The shareholders of a highly geared company reap
disproportionate benefits when earnings before interest and tax increase. This
is because interest payable on a large proportion of total finance remains
unchanged. The converse is also true, and a highly geared company is likely to
find itself in severe financial difficulties if it suffers a succession of
trading losses. It is not possible to specify an optimal level of gearing for companies
but, as a general rule, gearing should be low in those industries where demand
is volatile and profits are subject to fluctuation. A debt-equity ratio which
shows a declining trend over the years is usually taken as a positive sign
reflecting on increasing cash accrual and debt repayment. In fact, one of the
indicators of a unit turning sick is rising debt-equity ratio. Usually in
calculating the ratio, the preference share capital is excluded from debt, but
if the ratio is to show effect of use of fixed interest sources on earnings available
to the shareholders then it is to be included. On the other hand, if the ratio
is to examine financial solvency, then preference shares shall form part of the
capital.
Advantages
/ Uses of Debt-Equity Ratio
a. This
ratio is a measure of contribution of owners to the business as compared to
long-term creditors.
b. It tests
the long-term liquidity or solvency of an organization.
2. Shareholders
Equity Ratio
This ratio
is calculated as follows:
Shareholders Equity
Total Assets (tangible)
It is
assumed that larger the proportion of the shareholders’ equity, the stronger is
the financial position of the firm. This ration will supplement the debt-equity
ratio. In this ratio the relationship is established between the shareholders’
funds and the total assets. Shareholders’ funds represent equity and preference
capital plus reserves and surplus less accumulated losses. A reduction in shareholders
equity signalling the over dependence on outside sources for long-term
financial needs and this carries the risk of higher levels of gearing. This
ration indicates the degree to which unsecured creditors are protected against
loss in the event of liquidation.
3.
Long-term Debt to Shareholders Net worth Ratio
This ratio
is calculated as follows:
Long-term
Debt
Shareholders Net
worth
The ratio
compares long-term debt to the net worth of the firm i.e. the capital and fresh
reserves less intangible assets. This ratio is finer than the debt equity ratio
and includes capital which is invested in fictitious assets like deferred
expenditure and carried forward losses. This ratio would be of more interest to
the contributories of long-term finance to the firm, as the ratio gives a factual
idea of the assets available to meet the long term liabilities.
4.
Capital Gearing Ratio
It is the proportion
of fixed interest bearing funds to equity shareholders funds:
Fixed interest
earing Funds
Equity
Shareholder’s Funds
The fixed
interest bearing funds include debentures, long term loans and preference share
capital. The equity shareholders funds include equity share capital, reserves
and surplus. Capital gearing ratio indicates the degree of vulnerability of
earning available for equity shareholders. This ratio signals the firm which is
operating on trading on equity. It also indicates the changes in benefits
accruing to equity shareholders by changing the levels of fixed interest
bearing funds in the organization.
Advantages
of Capital Gearing Ratio
a. Capital
gearing ratio measures the company’s capitalization.
b. This
ratio is useful to the new investors for making sound investment decision.
c. Capital
gearing ratio shows the claim of owners as against the claim of lenders and
preference share holders.
5. Fixed
Assets to Long-Term Funds Ratio
The fixed
assets are shown as a proportion to long-term funds as follows:
Fixed
Assets
Long-term
Funds
This ratio
indicates the proportion of long-term funds deployed in fixed assets. Fixed
assets represent the gross fixed assets minus depreciation provided on this
till the date of calculation. Long-term funds include share capital, reserves
and surplus and long-term loans. The higher the ratio indicates the safer the
funds available in case of liquidation. It also indicates the proportion of
long-term funds that is invested in working capital.
6.
Proprietary Ratio
It expresses
the relationship between shareholders’ net worth and total assets.
Shareholders Net worth
Total Assets
Net worth
= Equity share capital + Preference share capital + Reserves – Fictitious
assets.
Total
assets = Fixed assets + Current assets – Fictitious assets
Reserves
earmarked specifically for a particular purpose should not be included in
calculation of net worth. A high proprietary ratio is indicative of strong
financial position of the business. The higher the ratio, the better it is. Advantages
or uses of Proprietary Ratio It also shows the relation between own fund and
borrowed fund. It shows the amount of proprietors funds invested in the total assets
of the firm.
7.
Interest Cover
The interest
coverage ratio shows how many times interest charges are covered by funds that
are available for payment of interest.
Profit before
interest, Depreciation and Tax
Interest
A very high
ratio indicates that the firm is conservative in using debt and a very low
ratio indicates excessive use of debt. Interest cove indicates how many times a
company can cover its current interest payment out of current profits. It gives
an indication of problem in servicing the debt. An interest cover of more than
7 times is regarded as safe and more than 3 times is desirable. An interest
cover of 2 times is considered reasonable by financial institutions.
8. Debt
Service Coverage Ratio (DSCR)
This ratio
is the key indicator to the lender to assess the extent of ability of the
borrower to service the loan in regard to timely payment of interest and
repayment of loan installment. It indicates whether the business is earning
sufficient profits to pay not only the interest charges, but also the
installments due of the principal amount. The ratio is calculated as follows :
Profit after taxes +
Depreciation + Interest on Loan
Interest on
Loan + Loan repayment in a year
A ratio of 2
is considered satisfactory by the financial institutions. The greater debt
service coverage ratio indicates the better debt servicing capacity of the
organization. By means of cash flow projection, the borrower should work DSCR
for the entire duration of the loan. This will enable the lender to take
correct view of the borrower’s repayment capacity.
9.
Dividend Cover
This ratio
indicates the number of times the dividends are covered by net profit. This
highlights the amount retained by a company for financing of future operations.
a)
Preference Dividend Cover
Net profit
after tax
Preference
Dividend
b) Equity
Dividend Cover
Net Profit Tax –
Preference Dividend
Equity Dividend
Use of
Advantages of Debtor Turnover Ratio
1. This
ratio helps to monitor credit and collection policies. It can signal the need
for corrective action particularly if compared with a norm.
2. This
ratio highlights the impact of management policies on the liquidity of the
enterprise as well as its profitability. It is a barometer of the general state
of health of an enterprise.
3. It is easy to understand, particularly when expressed as debtors’ collection period.
If you want exam most important question bank pdf then you have to pay per subject 100/- rupees only .
Contact 8652719712 / 8779537141
Telegram Group
Mumbai Univeersity :- https://t.me/mumbaiuniversityidolSuraj Patel Education :- https://t.me/surajpateleducationF.Y.J.C EXAM :- https://t.me/FYJCexamS.Y.J.C EXAM :- https://t.me/SYJCexamF.Y EXAM :- https://t.me/fyexamS.Y EXAM :- https://t.me/syexamT.Y EXAM :- https://t.me/tyexamM.Com Part 1 EXAM :- https://t.me/McomPart1ExamM.Com Part 2 EXAM :- https://t.me/McomPart2ExamM.A EXAM :- https://t.me/mastudentsexam YouTube Channel
https://www.youtube.com/channel/UCv8JIY58xfWHUIXVu9wxNHw
YouTube Channel
https://www.youtube.com/channel/UCv8JIY58xfWHUIXVu9wxNHw
- Mumbai University corporate finance M.com Semester 2 questions and answers
- M.com Corporate Finance Questions and Answers Part - 1
- M.com Part 1 Semester 2 corporate finance questions and answers
- M.com part 1 sem 2 corporate finance ,Mumbai university question papers
- m.com. semester - ii (cbcs) corporate finance questions and answers
- corporate finance mumbai university solved question papers download pdf
- corporate finance m.com sem 2 imp questions pdf mumbai university
- corporate finance m.com sem 2 pdf mumbai university
- m.com part 1 sem 2 corporate finance mcq pdf
- m.com part 1 question papers with answers idol
- m.com question papers with answers pdf mumbai university
- m.com part 1 sem 2 corporate finance book pdf
- m.com sem 2 corporate finance question paper
- corporate finance m.com sem 2 manan prakashan
- m.com question papers with answers pdf mumbai university
- m.com question papers with answers pdf mumbai university part 2
- m.com question papers with answers pdf mumbai university
- m.com question papers with answers pdf mumbai university part 2