Page 200 - DMGT202_COST_AND_MANAGEMENT_ACCOUNTING

Unit 11: Ratio Analysis

Long-term Debt-equity Ratio Notes

It is a ratio expressing the relationship in between the outsiders’ contribution through debt

financial resource and shareholders’ contribution through equity share capital, preference share

capital and past accumulated profits. It reveals the cover or cushion enjoyed by the firm due to

the owners’ contribution over the outsiders’ contribution.
Debt (Long-term Debt = Debentures/Term Loans)
Debt-equity Ratio =
Net Worth/Equity (Shareholders' Fund)
Example: The long-term debt of company ABC is ` 3 crores and the networth of the
company is ` 5 crores. What is the long-term debt-equity ratio of ABC?
Solution:
Debt
Long-term debt-equity Ratio = = 3/5 = .6
Net Worth

Higher ratio indicates the riskier financial status of the firm which means that the firm has been

financed by the greater outsiders’ fund rather than that of the owners’ fund contribution and
vice versa.
!
Caution Standard norm of the Debt-Equity Ratio:
The ideal norm is 1:2 which means that every one rupee of debt finance is covered by two

rupees of shareholders’ fund.

The firm should have a minimum of 50% margin of safety in meeting the long-term fi nancial
commitments. If the ratio exceeds the specification, the interest of the firm will be ruined by the

outsiders’ during the moment at when they are unable to make the payment of interest in time as
per the terms of agreement reached earlier. During the moment of liquidation, the greater ratio
may facilitate the creditors to recover the amount due lesser holding held by the owners.
Total Debt-equity Ratio

The ultimate purpose of the ratio is to express the relationship total volume of debt irrespective
of nature and shareholders’ funds. If the owners’ contribution is lesser in volume in general
irrespective of its nature leads to worse situation in recovering the amount of outsiders’
contribution during the moment of liquidation.

Short-term Debt + Long-term Debt
Total Debt-equity Ratio =
Equity (Shareholders' Fund)
Example: The long-term debt of company ABC is ` 3 crores and the networth of the
company is ` 5 crores. If the company has a short term debt of ` 1 crore, what is the total debt-
equity ratio of ABC?

Solution:
Short-term Debt + Long-term Debt 1+3
Total Debt-equity Ratio = = = 4:5
Equity(Shareholders' Fund) 5
11.5.2 Proprietary Ratio

The ratio illustrates the relationship in between the owners’ contribution and the total volume of
assets. In simple words, how much funds are contributed by the owners in financing the assets

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