Ratio Analysis– Part 3 Leverage · PDF fileRatio Analysis– Part 3 ... Paper 3B:...

Ratio Analysis– Part 3 Leverage Ratios Paper 3B: Financial Management Chapter 3 Unit I

CA B. Hari Gopal B.com, PGDBA, FCA, FCMA, DISA(ICAI), PMP (PMI, USA), EPBM (IIMC), MCT

Learning Objectives

1. Understand the concept and purpose of Leverage Ratios

2. Learn the classification of Leverage Ratios

2

Introduction to Leverage Ratios

• Background • Types of Leverage Ratios

3

Leverage Ratios - Background

Meaning of Leverage Ratios

Purpose of Leverage Ratios

4

Classification of Leverage Ratios

Classified in to two groups

Capital Structure Ratios

Coverage Ratios

5

Capital Structure ratios

6

7

Capital Structure Ratios

3. Debt – Equity Ratio

2. Debt Ratio

1. Equity Ratio

8

Equity ratio

9

Equity Ratio

Higher proportion of owner’s fund indicate lower degree of risk

Formulae: Shareholder’s Equity / Total Capital Employed

Indicate the proportion of Owner’s fund to Total funds invested

10

Debt ratio

11

Debt Ratio

Indicate the proportion of borrowed fund to Total Capital invested

Formulae: Total Debt / Total Capital Employed

Used to analyze the long term solvency of a firm

12

Debt – Equity ratio

13

Debt – Equity Ratio This ratio indicates the proportion of debt fund in relation to equity

Lenders are very keen to know this ratio since this shows relative weights of debt and equity

A high ratio means less protection for Creditors

Formulae – Total liabilities * / Shareholder’s Equity ( * interest bearing long term debt alone used)

Indicator of leverage.

14

Coverage Ratios

15

16

Coverage ratios

Debt Service Coverage Ratio

Interest Coverage Ratio

Preference Dividend Coverage Ratio

Capital Gearing Ratio

Fixed Assets – Long Term Funds Ratio

Proprietary Ratio

17

Debt Service Coverage Ratio

18

Debt Service Coverage Ratio

Lenders are interested in judging the firm’s ability to pay off current interest and installments

Formulae – Earnings for debt service / (Interest + Installments)

Earnings for debt service – Net Profit + Non-cash expenses + Non-operating adjustments + Interest on Debt fund

19

Interest Coverage Ratio

20

Interest Coverage Ratio

Higher ratio means that the firm can easily meet its interest obligations, even if EBIT suffer

considerable decline.

Formulae – EBIT/ Interest

Also known as “times interest earned ratio”, indicates firm’s ability to meet interest and other

fixed charges obligations

21

Preference Dividend Coverage Ratio

22

Preference Dividend Coverage Ratio

Higher ratio is preferable from Preference shareholders point of view

Formulae – EAT / Preference Dividend

Measures firm’s ability to pay dividend on Preference shares which carry fixed rate of

return.

23

Capital Gearing Ratio

24

Capital Gearing Ratio

Shows the proportion of fixed interest (Dividend) bearing capital to Shareholder’s Equity

Formulae – (Preference Share Capital + Debentures + Long Term Loans) / (Equity Share Capital + reserves and Surplus - Losses)

25

Other Ratios •Fixed Assets to Long Term Fund Ratio

•Proprietary Ratio

26

Fixed Assets – Long Term Fund Ratio

If it is more than 1, it means short term funds are used to finance fixed assets. During expansion,

companies often resort to this practice

Formulae – Fixed Assets / Long Term funds

It is expected that Fixed assets and core working capital are to be covered by long term funds.

Ideally this should be less than 1.

27

Proprietary Ratio

This ratio indicates the proportion of Proprietary Funds to Total Assets .

Formulae – Proprietary Funds / Total Assets

Proprietary fund = Equity & Preference Share capital + Reserves – Fictitious assets & losses

Total Assets excludes Fictitious assets and losses

28

Testing time

29

Leverage Ratios - Multiple Choice Questions

30

MCQ – 1

Two types of leverage ratios are –

C. Capital Structure & Coverage Ratios

D. Profitability & Liquidity Ratios

Answer: C. Capital Structure & Coverage Ratios

A. Capital Structure & Liquidity Ratios

B. Capital Structure & Profitability Ratios

31

MCQ – 2

______Measures the firm’s ability to service the fixed liabilities

A. Capital Structure Ratios

C. Liquidity Ratios

B. Profitability Ratios

D. Coverage Ratios

Answer : D. Coverage Ratios

32

MCQ – 3

Lenders are interested in __________ to judge the firm’s ability to pay off current interest and installments

A. Debt Ratio

C. Debt-Equity Ratio

B. Debt Service Coverage Ratio

D. None of the above

Answer : B. Debt Service Coverage Ratio

33

MCQ – 4

_________ is the indicator of leverage

A. Debt Ratio

C. Debt-Equity Ratio

B. Debt Service Coverage Ratio

D. None of the above

Answer : C. Debt-Equity Ratio

34

MCQ – 5

The ratio, which indicates the proportion of owner’s fund to total fund invested in the business

Answer : D. Equity Ratio

A. Debt Ratio

C. Debt-Equity Ratio

B. Debt Service Coverage Ratio

D. Equity Ratio

35

MCQ – 6

The ratio, which indicates the margin of safety available to preference shareholders is –

Answer : D. Preference Dividend Coverage Ratio

A. Interest Coverage Ratio

C. Debt-Equity Ratio

B. Debt Service Coverage Ratio

D. Preference Dividend Coverage Ratio

36

MCQ – 7

Proprietary ratio measures the relationship between –

A. Proprietary fund & Capital Employed

C. Total Assets & Long Term Funds

B. Proprietary fund & Total Assets

D. Proprietary fund & Current Assets

Answer : B. Proprietary fund & Total Assets

Lesson Summary

37

3. We had discussed the Capital Structure Ratios and Coverage Ratios

2. We had also seen the classification of Leverage ratios and discussed the ratios under

two groups

1. We have learnt the meaning and purpose of Leverage ratios

What Next ……

38

Follow the below Presentations

Ratio Analysis Part 1 – Overview

Ratio Analysis Part 2 - Liquidity Ratios

Ratio Analysis Part 4 - Activity Ratios

Ratio Analysis Part 5 - Profitability Ratios

39

Thank You

40