Concept And Types Of Leverage Ratios

Leverage ratios are also called long-term solvency ratios or capital structure ratios. The term 'solvency' implies the ability of a company to meet the payments associated with its long-term debts. Thus solvency ratios are the measure of the company's ability to meet its long-term obligations. Generally, leverage ratios are expressed in proportions. However, if the ratio is in fraction or less than one, it is expressed in percentage.
The following are the major types of leverage ratios:

1. Debt-equity Ratio
2. Debt to total capital ratio

1. Debt-Equity Ratio

Debt-equity ratio is calculated to ascertain the soundness of the company's long-term financial position. Debt-equity ratio indicates the extend to which it depends upon borrowed funds for its existence. It portrays the proportion of its total funds acquired by way of external financing.
The debt-equity ratio is ascertained by using the following formula:

Debt-Equity Ratio = Long term debt/Shareholders' fund
Debt-Equity Ratio = Total debt/Total shareholders fund

Long-term debt

The debt which is payable after current year is called long term debt. Long term debt include term loans,debentures, bonds, mortgage loans and secured loans.

Total debt

Total debt includes both short term and long term debt. Short term debts are the current liabilities.

Shareholders' Fund

Shareholders' fund is also known as net worth or shareholders' equity.It is the amount which belongs to the company's shareholders or owners.

2. Debt To Total Capital Ratio

Debt to total capital ratio shows the relationship between long term debt and total capital employed by the company. Total capital includes long term liabilities plus shareholders' equity. Total capital is also regarded as permanent capital or capital employed or long term fund. Debt to total capital ratio is ascertained by using the following formula.

Debt to total capital ratio = Long term debt/Total capital Or, Total debt/Total capital

* Total Debt = Long term debt+Current liabilities
* Total Capital = Long term debt+Shareholder's fund

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Concept And Types Of Profitability Ratios
Concept And Types Of Turnover Ratios
Concept And Types Of Liquidity Ratios

Concept And Types Of Liquidity Ratios

Liquidity represents one's ability to pay its current obligations or short-term debts within a period less than one year. Liquidity ratios, therefore, measures a company's liquidity position. The ratios are important from the viewpoint of its creditors as well as management. The liquidity position of the company can be measured mainly by using two liquidity ratios such as follows.
a. Current Ratio
b. Quick Ratio

a. Current Ratio

Current ratio is also known as short-term solvency ratio or working capital ratio. Current ratio is used to assess the short-term financial position of the business. In other words, it is an indicator of the firm's ability to meet its short-term obligations.
Current ratio is calculated by using following formula:

Current ratio = Current assets/Current liabilities

Current assets are cash and those cash equivalent of a business which can be converted into cash within a short period of time not exceeding a year. Cash in hand, cash at bank, bills receivables, sundry debtors, accrued incomes, prepaid expenses, inventory, short term loans provided , advance given etc are the examples of current assets.

Current liabilities are those obligations of a business, which are to be paid within in a short period of time not exceeding a year. Bills payable ,sundry creditors, short term loan taken, income tax payable, dividend payable, advance incomes, accrued expenses are the examples of current liabilities.

b. Quick Ratio

Quick ratio is another measure of a company's liquidity. Quick ratio is also known as liquid ratio or acid test ratio. However, although it is used to test the short-term solvency or liquidity position of the firm, it is a more stringent measure of liquidity than the current ratio. This ratio is calculated by dividing liquid assets by current liabilities. Liquid assets are cash and other assets which are either equivalent to cash or convertible into cash within a very short period of time.
The following formula is used to calculate quick ratio:

Quick Ratio = Liquid assets/Current Liabilities

Liquid assets = Total current assets - stock- prepaid expenses

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Classification Of Accounting Ratios

Accounting ratios can be classified from different point of view. Ratios may be used to evaluate the company's liquidity, efficiency, leverage and profitability. The ratios may be classified as following.

1. Liquidity Ratios
a. Current Ratio
b. Quick Ratio

2. Leverage Ratios
a. Debt-equity ratio
b. Debt to total capital ratio

3. Turnover Ratios
a. Inventory turnover ratio
b. Debtors turnover ratio
c. Average collection period
d. Total assets turnover ratio
e. Fixed assets turnover ratio
f. Capital employed turnover ratio

4. Profitability Ratios
a. Profitability in relation to sales
b. Profitability in relation to investment
c. Profitability in terms of earnings and dividend

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Meaning Of Ratio Analysis And Presentation Of Ratio
Importance And Advantages Of Ratio Analysis
Nature Of Ratio Analysis
Limitations Of Ratio Analysis

Nature Of Ratio Analysis

In financial analysis, ratio is used as an index of yardstick for evaluating the financial position and performance of the firm. It is a technique of analysis and interpretation of financial statements. Ratio analysis helps in making decisions as it helps establishing relationship between various ratios and interpret thereon. Ratio analysis helps analysts to make quantitative judgement about the financial position and performance of the firm. Ratio analysis involves following steps:

1. Relevant data selection from the financial statements related to the objectives of the analysis.

2. Calculation of required ratios from the data and presenting them either in pure ratio form or in percentage.

3. Comparison of derived different ratios with:
i. The ratio of the same concern over a period of years to know upward or downward trend or static position to help in estimating the future, or
ii. The ratios of another firm in same line, or
iii. The ratios of projected financial statements, or
iv. The ratios of industry average, or
v. The predetermined standards, or
vi. The ratios between the departments of the same concern assessing either the financial position or the profitability or both.

4. Interpretation of the ratio

Ratio analysis uses financial report and data and summarizes the key relationship in order to appraise financial performance. The effectiveness will be greatly improved when trends are identified, comparative ratios are available and inter-related ratios are prepared.
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Meaning Of Ratio Analysis And Presentation Of Ratio
Importance And Advantages Of Ratio Analysis
Limitations Of Ratio Analysis

Importance And Advantages Of Ratio Analysis

Ratio analysis is an important tool for analyzing the company's financial performance. The following are the importance and advantages of the accounting ratios.

1. Analyzing Financial Statements

Ratio analysis is an important technique of financial statement analysis. Accounting ratios are useful for understanding the financial position of the company. Different users such as investors, management. bankers and creditors use the ratio to analyze the financial situation of the company for their decision making purpose.

2. Judging Efficiency

Accounting ratios are important for judging the company's efficiency in terms of its operations and management. They help judge how well the company has been able to utilize its assets and earn profits.

3. Locating Weakness

Accounting ratios can also be used in locating weakness of the company's operations even though its overall performance may be quite good. Management can then pay attention to the weakness and take remedial measures to overcome them.

4. Formulating Plans

Although accounting ratios are used to analyze the company's past financial performance, they can also be used to establish future trends of its financial performance. As a result, they help formulate the company's future plans.

5. Comparing Performance

It is essential for a company to know how well it is performing over the years and as compared to the other firms of the similar nature. Besides, it is also important to know how well its different divisions are performing among themselves in different years. Ratio analysis facilitates such comparison.

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Nature Of Ratio Analysis
Limitations Of Ratio Analysis

Meaning Of Ratio Analysis And Presentation Of Ratio

Concept And Meaning Of Ratio Analysis

Financial statement analysis the process of analyzing financial statements of a company so as to obtain meaningful information about its survival, stability, profitability, solvency and growth prospect. The financial statement analysis can be performed by using a number of techniques such as comparative statements, common size statements and ratio analysis. Ratio analysis is the most popularly and widely used technique of financial statement analysis.

In a simple word, ratio is a quotient of two numerical variables, which shows the relationship between the two figures. Accordingly, accounting ratio is a relationship between two numerical variables obtained from financial statements such as income statements and balance sheet. The income statement or profit and loss account shows the operating results in terms of net profit or loss of a company for a specific period. The balance sheet, on the other hand, shows the financial position of the company at the end of that period. Accounting ratios are used as an important tool of analyzing the financial performance of the company over the years and its comparative position among other companies in the industry.

Ratio analysis is the process of determining and interpreting numerical relationship between figures of financial statements. Since an absolute accounting figure often often does not provide much meaning by itself, it has to be analyze in relation to other figures so that significant information about the company's financial performance can be derived.

Ratio analysis is a process of determining and presenting the quantitative relationship between two accounting figures to evaluate the strengths and weakness of a business. It is important from the point of view of investors, creditors and management for analysis and interpretation of a firm's financial health.

Presentation Of Ratio

Ratio can be expressed in the following terms:

1. Ratio method

Ratio method shows the relationship between two figures in ratio or proportion. It is expressed by simple division of one item by another eg. 2.5:1,0.5:1 and so on.

2. Rate method

This method shows relationship in rate or times, like 2 times or 4 times and so on.

3. Percentage method

The relationship between two figures can be presented in percentage like 20%, 30% and so on.

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Importance And Advantages Of Ratio Analysis
Nature Of Ratio Analysis
Limitations Of Ratio Analysis

Parties Interested In Financial Statement Analysis

The analysis of financial figures contained in the company's profit and loss account and balance sheet by employing appropriate technique is known a financial statement analysis. Financial statement analysis is useful to different parties to obtain the required information about the organization. Following are the parties interested in financial statement analysis.

1. Shareholders

Shareholders are interested in financial statement analysis to know the profitability of the organization. Profitability shows the growth potentiality of an organization and safety of investment of shareholders.

2. Investors And Lenders

Investors and lenders are interested to know the solvency position of an organization. They analyze the financial statement position to know about the safety of their investment and ability to pay interest and repayment of principle amount on due date.

3. Creditors

Creditors are interested in analyzing the financial statements in order to know the short term liquidity position of an organization. Creditors analyse the financial statement to know either the organization is enable to pay the amount of short term liabilities on due date.

4. Management

Management is interested to analyze the financial statement for measuring the effectiveness of its policies and decisions.It analyze the financial statements to know short term and long term solvency position,profitability,liquidity position and return on investment from the business.


Government is interested to analyze the financial position in determining the amount of tax liability. It also helps for formulating effective plans and policies for economic growth.

Related Topics
Objectives Of Financial Statement Analysis
Methods Of Financial Statement Analysis
Importance Of Financial Statement Analysis
Limitations Of Financial Statement Analysis

Limitations Of Financial Statement Analysis

Although analysis of financial statement is essential to obtain relevant information for making several decisions and formulating corporate plans and policies, it should be carefully performed as it suffers from a number of the following limitations.

1. Mislead the user

The accuracy of financial information largely depends on how accurately financial statements are prepared. If their preparation is wrong, the information obtained from their analysis will also be wrong which may mislead the user in making decisions.

2. Not useful for planning

Since financial statements are prepared by using historical financial data, therefore, the information derived from such statements may not be effective in corporate planning, if the previous situation does not prevail.

3. Qualitative aspects

Then financial statement analysis provides only quantitative information about the company's financial affairs. However, it fails to provide qualitative information such as management labor relation, customer's satisfaction, management's skills and so on which are also equally important for decision making.

4. Comparison not possible

The financial statements are based on historical data. Therefore comparative analysis of financial statements of different years can not be done as inflation distorts the view presented by the statements of different years.

5. Wrong judgement

This is another limitation or constraint of financial statement analysis.The skills used in the analysis without adequate knowledge of the subject matter may lead to negative direction . Similarly, biased attitude of the analyst may also lead to wrong judgement and conclusion.

The limitations mentioned above about financial statement analysis make it clear that the analysis is a means to an end and not an end to itself. The users and analysts must understand the limitations before analyzing the financial statements of the company.

Importance Of Financial Statement Analysis

The financial statement analysis is important for different reasons. The importance of financial statement analysis can be presented as follows:

1. Holding Of Share

Shareholders are the owners of the company. Time and again, they may have to take decisions whether they have to continue with the holdings of the company's share or sell them out. The financial statement analysis is important as it provides meaningful information to the shareholders in taking such decisions.

2. Decisions And Plans

The management of the company is responsible for taking decisions and formulating plans and policies for the future. They, therefore, always need to evaluate its performance and effectiveness of their action to realise the company's goal in the past. For that purpose, financial statement analysis is important to the company's management.

3. Extension Of Credit

The creditors are the providers of loan capital to the company.Therefore they may have to take decisions as to whether they have to extend their loans to the company and demand for higher interest rates. The financial statement analysis provides important information to them for their purpose.

4.Investment Decision

The prospective investors are those who have surplus capital to invest in some profitable opportunities. Therefore, they often have to decide whether to invest their capital in the company's share. The financial statement analysis is important to them because they can obtain useful information for their investment decision making purpose.

Methods Or Techniques Of Financial Statement Analysis

Financial statement analysis can be performed by employing a number of methods or techniques. The following are the important methods or techniques of financial statement analysis.

1. Ratio Analysis

Ratio analysis is the analysis of the interrelationship between two financial figures.

2. Cash Flow Analysis

Cash flow analysis is the analysis of the change in the cash position during a period.

3. Comparative Financial Statements

Comparative financial statement is a analysis of financial statements of the company for two years or of the two companies of similar types.

4. Trend Analysis

Trend analysis is the analysis of the trend of the financial ratios of the company over the years.

The methods to be selected for the analysis depend upon the circumstances and the users' need. The user or the analyst should use appropriate methods to derive required information to fulfill their needs.

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Objectives Of Financial Statement Analysis
Importance Of Financial Statement Analysis
Limitations Of Financial Statement Analysis

Objectives Of Financial Statement Analysis

Objectives of financial statement analysis are as follows

1. Assessment Of Past Performance

Past performance is a good indicator of future performance. Investors or creditors are interested in the trend of past sales, cost of good sold, operating expenses, net income, cash flows and return on investment. These trends offer a means for judging management's past performance and are possible indicators of future performance.

2. Assessment of current position

Financial statement analysis shows the current position of the firm in terms of the types of assets owned by a business firm and the different liabilities due against the enterprise.

3. Prediction of profitability and growth prospects

Financial statement analysis helps in assessing and predicting the earning prospects and growth rates in earning which are used by investors while comparing investment alternatives and other users in judging earning potential of business enterprise.

4. Prediction of bankruptcy and failure

Financial statement analysis is an important tool in assessing and predicting bankruptcy and probability of business failure.

5. Assessment of the operational efficiency

Financial statement analysis helps to assess the operational efficiency of the management of a company. The actual performance of the firm which are revealed in the financial statements can be compared with some standards set earlier and the deviation of any between standards and actual performance can be used as the indicator of efficiency of the management.