The relationship between borrowed funds and owner’s capital is a popular measure of the long-term financial solvency of a firm, This relationship is shown by the debt equity ratios. This ratio reflects the relative claims of creditors and shareholders against the assets of the firm. Alternatively, this ratio indicates the relative proportions of debt and equity in financing the assets of a firm. The relationship between outsiders’ claims and owner’s capital can be shown in different ways and accordingly, there are many variants of the debt-equity (D/E) ratio.
One approach is to express the D/E ratios in terms of the relative proportion of long-term debt and shareholders equity. Thus,
The debt considered here is exclusive of current liabilities. The share holders equity includes (i) equity and preference share capital, (ii) past accumulated profits but excludes fictitious assets like past accumulated losses, (iii) discount on issue of shares and so on. Another approach to the calculation of the debt-equity ratio is to relate the total debt (not merely long-term debt) to the shareholders’ equity. That is,
The D/E ratio is, thus, the ratio of total outside liabilities to owners total funds. In other words, it is the ratio of the amount invested by outsiders to the amount invested by the owners of business.
The difference between this and the first approach is essentially in respect of the treatment of current liabilities. While the former excludes them, includes them in the numerator (debt). Should current liabilities be included in the amount of debt to calculate the DIE ratio? While there is no doubt that current liabilities are short-term and the ability of a fum to meet such obligations is reflected in the liquidity ratios, their amount fluctuates widely during a year and interest payments on them are not large, they should firm part of the total outside liabilities to determine the ability of a firm to meet its long-term obligations for a number of reasons. For one thing, individual items of current liabilities are certainly short-term and may fluctuate widely, but, as a whole, a fixed amount of them is always in use so that they are available more or less on a long-term footing. Moreover, some current liabilities like bank credit, which are ostensibly short term, are renewed year after year and remain by and large permanently in the business. Also, current liabilities have, like the long-term creditors, a prior right on the assets of the business and are paid along with long-term lenders at the time of liquidation of the firm. Finally, the short-term creditors exercise as much, if not more, pressure on management. The omission of current liabilities in calculating the D/E ratio would lead to misleading results.
How should preference share capital be treated? Should it be included in the debt or equity? The exact treatment will depend upon the purpose for which the D/E ratio is being computed. If the object is to examine the financial solvency of a firm in terms of its ability to avoid financial risk, preference capital should be clubbed with equity capital. If, however, the D/E ratio is calculated to show the effect of the use of fixed-interest/dividend sources of funds on the earnings available to the ordinary shareholders, preference capital should be clubbed with debt.