Debt Equity Ratio

This ratio is calculated to know the long term financial position of the company. It shows the relation between the long term debts and shareholders fund or net equity of the company. It tells us that how much portion of the funds is acquired from long term borrowings. It is calculated as follows:

Debt Equity Ratio= Debt / Equity

OR

Debt Equity Ratio=Long Term Debts/Shareholder’s Funds

Here two terms are important – Debts or we can say Long term debts and Equity or we can say Shareholder’s Fund. Let’s know it.

Debt: It means Loans or Borrowings of the company. But we include only long term loans and provisions in this which mature after one year. Examples:

• Debentures
• Public Deposits
• Bank Loans (more than one year duration)
• Mortgage Loan
• Loan from Financial Institutions
• Long term Provisions

Equity: It means Shareholder’s fund or we can say Net Worth of the company. It includes share capital and Reserves & Surplus. Examples:

• Equity Share Capital (if any)
• Preference Share Capital (if any)
• Capital Reserve
• General Reserve
• Profit and Loss account Balance
• Premium on Securities

Ideal Ratio : 2:1

Example: Calculate Debt Equity Ratio from the following particulars:-

Equity Share Capital             ₹2,00,000

Preference Share Capital      ₹1,00,000

P & L Balance                     ₹50,000

Loan from Bank                  ₹3,00,000

General Reserve                  ₹1,20,000

11% Debentures                 ₹6,00,000

Current Liabilities                 ₹20,000

Securities Premium              ₹50,000

Solution:

Debt Equity Ratio = Debt / Equity

Debt = 11% Debentures + Loan from Bank

        = ₹6,00,000 + ₹3,00,000

        = ₹9,00,000

Equity = Equity Share Capital + Preference Share Capital +

             + P & L Balance + General Reserve + Securities

             Premium

          = ₹2,00,000 + ₹1,00,000 + ₹50,000 + ₹1,20,000 +

              ₹50,000

          = ₹5,20,000

Debt Equity Ratio = ₹9,00,000 / ₹5,20,000

                        = 1.73:1

Significance of the Ratio: This ratio shows the extent of funds provided by long term lenders in comparison to the funds provided by the owners. Generally, debt equity ratio of 2:1 is considered safe. If this ratio is higher than it, then it will indicate a risky financial position for long term lenders. If this ratio is lower than 2:1, then it is better for long term lenders because they are secure.

Quick Ratio

It shows the position of a firm to pay its current liabilities within a month or immediately. It is calculated as follows:

Quick Ratio = Liquid Assets / Current Liabilities

Here two terms are important. First is Liquid Assets and the second is Current Liabilities.

Liquid Assets: It means those assets which can be converted into cash very shortly. We can include all current assets excluding inventory and prepaid expenses in Liquid Assets. Because prepaid expenses are not expected to be converted in cash and inventory has to be sold for converting into cash. So Liquid Assets include mainly:

• ·         Current Investments
• ·       Trade Receivables (B/R and Sundry Debtors excluding any provision made on it)
• ·         Cash & Bank Balances
• ·         Short Term Loans and Advances

Current Liabilities: These are the liabilities of a business which are payable within 12 months within a period of operating cycle. These include the following items:

• ·         Short term borrowings (including overdraft from banks)
• ·         Short term provisions (provision for tax, proposed dividends)
• ·         Trade Payables (Creditors and B/P)
• ·    Other Current Liabilities (interest accrued on borrowings, income received in advance, outstanding expenses, current maturities of long term debts, calls in advance, unclaimed dividends)

Ideal Ratio: 1:1

Other names: Quick ratio is also known as Acid Test Ratio and Liquid Ratio.

Example: The current assets of a company are ₹30,000 and the current ratio is 1.5. The inventories stood at ₹10,000. Calculate the liquid ratio.

Solution:

Current Ratio = Current Assets / Current Liabilities

1.5                = ₹30,000 / Current Liabilities

Therefore, Current Liabilities = ₹30,000/1.5 = ₹20,000

Liquid Ratio = Liquid Assets / Current Liabilities

Liquid Assets = Current Assets – Inventories

                    = ₹30,000 – ₹10,000

                    = ₹20,000

Liquid Ratio = ₹20,000 / ₹20,000

                  = 1:1

Ideal Ratio is 1:1. In this case also the Liquid Ratio is 1:1. Thus we can say that short term financial position of the company is satisfactory.

Significance of the Ratio: This ratio is a better test of short term financial position of any company than the current ratio. Because in this ratio, we consider only those assets which can be easily converted into cash. If this ratio is more than 1:1 than it is considered to be better. Because it is thought that for every rupee of current liability there should at least one rupee of liquid asset. When this ratio is used with current ratio, it gives a better picture of the short term financial position of the company.