Select Page

Interpretation

As the ratio is like the D/E ratio, it gives results similar to the D/E ratio in respect of capital structure of a firm. The first of these (Equation 7.10), indicates what proportion of the permanent capital of a firm consists of long-term debt. If the ratio for a firm is i :2, it implies that one-third of the total permanent capital of the firm is in the form of long-term debts. Although no hard and fast rules exist; conventionally a ratio of 1 : 2 is considered to be satisfactory.

The second ratio (Equation 7.11) measures the share of the total assets financed by outside funds. The third variant (Equation 7.12) shows what portion of the total assets are financed by the owner’s capital. A low ratio of debt to total assets is desirable from the point of the creditors/ lenders as there is sufficient margin of safety available to them. But its implications for the shareholders are that debt is not being exploited to make available to them the benefit of trading on equity. A firm with a very high ratio would expose the creditors to higher risk. The implications of the ratio of equity capital of total assets are exactly opposite to that of the debt to total assets. A firm should have neither a very high ratio nor a very low ratio.

[vfb id=1]

Share This