Page 126 - DMGT403_ACCOUNTING_FOR_MANAGERS

Unit 6: Financial Statements: Analysis and Interpretation

Higher ratio indicates the riskier financial status of the firm which means that the firm has been Notes
financed by the greater outsiders' fund rather than that of the owners' fund contribution and
vice-versa.

Notes 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 financial
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
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
of the firm. Greater the ratio means that greater contribution made by the owners' in financing
the assets.
Owners' Funds or Equity or Shareholders' Funds
Proprietary Ratio =
Total Assets

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