Question

Long-term solvency is indicated by .

• A. Liquidity ratio
• B. Debt-equity ratio
• C. Interest coverage ratio
• D. Return on capital employed
• E. Both (B) and (D) above

Answer 1

The correct option is B Debt-equity ratio

Debt-equity ratio = Long term debts / Shareholders funds

Debt-equity ratio indicates the long-term solvency of a firm by analyzing the relative proportions of capital contribution by creditors and shareholders.

Scenario $1$ Long term debts = $Rs.150000$ and Shareholders funds = $Rs.125000$

Scenario $2$ Long term debts = $Rs.150000$ and Shareholders funds = $Rs.100000$

Debt-equity ratio :

Scenario 1 = $150000/125000$ = $1.2:1$

Scenario 2 = $150000/100000$ = $1.5:1$

So, in scenario 1 the debt-equity ratio is $1.2:1$ which means that the outside liabilities are only 0.2 times more than the shareholders funds whereas in scenario 2 the debt-equity ratio is $1.5:1$ which means that the outside liabilities are 0.5 times more than the shareholders funds.

On analyzing scenario 1 and 2 we can see that the protection to the debt holders is more in scenario 1 than in scenario 2.