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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
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Introduction to Leverage Ratios
• Background • Types of Leverage Ratios
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Leverage Ratios - Background
Meaning of Leverage Ratios
Purpose of Leverage Ratios
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Classification of Leverage Ratios
Classified in to two groups
Capital Structure Ratios
Coverage Ratios
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Capital Structure ratios
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Capital Structure Ratios
3. Debt – Equity Ratio
2. Debt Ratio
1. Equity Ratio
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Equity ratio
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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
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Debt ratio
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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
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Debt – Equity ratio
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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.
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Coverage Ratios
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Coverage ratios
Debt Service Coverage Ratio
Interest Coverage Ratio
Preference Dividend Coverage Ratio
Capital Gearing Ratio
Fixed Assets – Long Term Funds Ratio
Proprietary Ratio
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Debt Service Coverage Ratio
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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
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Interest Coverage Ratio
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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
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Preference Dividend Coverage Ratio
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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.
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Capital Gearing Ratio
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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)
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Other Ratios •Fixed Assets to Long Term Fund Ratio
•Proprietary Ratio
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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.
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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
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Testing time
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Leverage Ratios - Multiple Choice Questions
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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
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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
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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
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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
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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
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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
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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
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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 ……
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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
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Thank You
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