Welcome students. So, we are in the process
of discussing the ratio analysis and in the last part of discussion we have discussed,
we have talked about say the first category of the ratios that was the RoI ratios.
. And these ratios are we talked about their
we talked about the 3 ratios that is return on net worth that is earning per share and
cash earning per share then we have the next set of the ratio that is they are called as
the solvency ratios. . And solvency ratios are solvency ratios, solvency
means as the word says solvency. I told you in the past also that solvency means how strength
full how strong the firm is how strength full or how strong the firm is that is the solvency.
So, in this case solvency ratios tell us about the performance of the company about the overall
financial and operating health of the company largely we talk about the financial health
of the company. So, solvency is means there are 2 words solvency and insolvency solvency
and insolvency. So, when it is solvency how strength full for the company is how strength
full the financial structure of the company is and insolvency means when the company is
not doing well that is the insolvency company. Now we want to study that how strength full
the company is how strong the company is what is the future scope of the growth of the company
because ultimately you need the funds. When you need the funds you have to look at
it from the 2 angles. Every company has certain borrowing capacity and if that borrowing capacity
is already exhausted then we do not have the future or the further borrowing capacity for
expansion diversification and any kind of growth one. But if that capacity is not exhausted
this company is doing the entire business from its own resources there are 2 sources
of doing the business – one source is the internal sources of funds and internal sources
of fund and second is the external sources of funds internal source of fund is that the
funds come from the shareholders of the owners of the company and that is the share capital
first this is the share capital and then it is the reserves and surplus or you call it
as reserves and surplus or you call it as free reserves; free reserves.
Reserve and surplus or free reserves these are the internal funds. So, when we start
the business initially when we start the business may be as sole proprietary as a partnership
firm or as a private company or as a public company we have only internal source of the
fund until and unless we go to the venture capitalist. Venture capitalist can provide
us the external source of funding, but they have so many there are, so many disadvantages
of the venture capitalist as rate of return their interference in the company’s management
and so on and so forth. So, we normally do not like to go to the venture capitalist if
it is having if it is sufficient to have the funds from the internal sources and then doing
the business at the say lower scale at the small laborer with these funds and then developing
or generating the funds internally, growing with the capital appreciating the capital
and then when the company reaches at a point at level when the solvency of the company
increases when strength of the company increases then outside funding also start becoming available,
external sources also start pouring in the kitty of the companies funds. So, for example,
you talk about the loans. If we are going to set up a new company or
a new business organization business firm we if go to the bank that please I want to
start a company my requirement is 20,00,000, I have got 10,00,000 with me and you give
me 10,00,000 rupees with me bank would say that what is the credibility of your company
and what is the security of our parts. So, finally, you whatever the way you try
to convince them they said that no, it is not possible first prove your credibility
and once we feel that our funds are secured and our investment is going to have the say
fruitful return then its fine we can think about you. So, initially you do not have the
funds. So, you have the funds only internal funds that is the share capital and first
year of the operation will do with that as the lower scale and you earn the profit in
the first year second year third year then we will keep on re-investing that profit back
in the capital initially we do not draw dividend out of the companies investments we do not
draw any dividend out of the companies investment. So, only it is the share capital and then
we create the reserves and reserve and surplus is create and add it back and then capital
of the company keep on appreciating, appreciating and when continuously we have the profitability
and profitability in the form is growing. So, ultimately you see the solvency of the
firm is growing when the solvency instance of the financial strengths of the firm are
growing in that case you can expect that now many external source will also be available.
So, in this case we talk about first internal source of funds and we would like to exhaust
these internal source of you funds your capital reserve and surplus and free reserve completely
and after that we will look forward for or towards the external funds or external sources
of the funds, and external source of funds are like bank loans or debentures or bonds
or something like that or maybe selling the coming out with the IPO in the market or selling
the shares in the market it to some extent that is also called as external source later
on it becomes internal source. But those potential shareholders withholds would also be interested
to buy the shares from of your company if you have proven track record and we are going
to assurance to the people that yes we are going to give them a better or assured returns
then only the people are going to buy the shares of the company.
Till then even in a public limited company also IPOs are not brought in initial promoters
7 promoters provide the funds they make investment of the capital and they do not like to go
for the IPO because if the company does not turn on enjoy a good brand name or good reputation
in the market and if company comes out with an IPO and if the IPO is not properly subscribed
or well subscribed in that case it creates the problem. So, till then we have to use
internal sources that is the funds provided by the initial seven shareholders and then
the profits and profits have to reinvested back and when we keep on say when this capital
base improves or strengthen then the external sources can be expected.
So, it means in the solvency ratios we have to think about that how much internal funds
were invested by the firm, how these funds are utilized by the firm, how much wealth
is created by utilizing the internal source of the funds by the company and then how we
can expect or to what extent we can see expect the external support or the external sources
of support from the external sources. . So, here it is the first ratio which we are
going to calculate here is that is the NAV net asset value or first solvency ratio is
a the NAV which is called as net asset value and this net asset value is that is the equity
shareholders fund, equity shareholders fund divided by total number of total number of
equity shares equity shares outstanding, total number of equity shares outstanding n a v
sorry NAV means net worth asset value net asset value means or you can call it as net
worth, net worth divided by total number of equity shares outstanding net worth divided
by the total number of equity shares outstanding. Means how much shares are there in the market
sold by the company and how much shares are represented or justified by the net worth
of the company how much net worth is there and how much total number of equity shares
are there for example, net worth of the company is 10,000 and then total number of shares
are 1000 it means net worth per share is 10 rupees, net worth per share is 10 rupees.
Now, there may be a case that the company has only net worth they have not borrowed
even a single penny from the market whatever the investment is made that is made because
net worth is paid up capital paid up equity capital paid up capital plus free reserves
plus free reserves these are the 2 things. So, paid up means capital contributed by the
7 share holders plus free reserves are those reserves which are now finally, owned by are
available to the equity shareholders it has no claim against or it has nobody else has
a claim against the free reserves. So, these are the 2 things which made the net worth
and if you see if the total business by the companies being run with the help of net worth
all the assets are funded from the net worth only that is the paid up capital and free
reserves in that case you can make out that what is a solvency position of the firm.
For example some company started the business initially with a sum of rupees 1,00,000 sum
of rupees 1,00,000 and today say after say 3 years the company’s total net worth has
become 2,00,000 it means they have added on lakh worth of rupees from the internal generation.
They have efficiently use their own money that is 1,00,000 rupees and they have generated
a profit almost one-third of the capital is added every year in the form of the profit
and now the company’s network has become 2,00,000 rupees and there is not even a single
penny as a outsiders obligation of outsiders fund that is the loan or the borrowed capital
or the borrowed money. Now, how strength full it is that 2,00,000
rupees it means it is a highly profitable firm they are earning about 33 percent of
the profit every year and they are appreciating their capital by reinvesting that entire amount
of the profit and in the 3 years period of time 1,00,000 rupees off the net worth or
the capital has become 2,00,000 rupees it means 100 percent increase. Now you see this
situation if they want to come out with an IPO and if they give this kind of information
in the newspaper or in the electronic media everybody will be allowed to subscribe to
the shares of this company. Second thing is that if you want to borrow money from the
financial institutions or from any other source then there is no issue at all there is no
problem at all every banker would be say would be all the leading banks would be lining up
outside the office of this company that this company is say solvency structure is so strong
and solvency structure is so strong this company. So, solvent that it is the say generate a
very good returns very good profits and this if you talk about the potential shareholders
they say that very good return on investment will be available because of the very high
solvency of the company one. And second thing would be that financial institutions
will feel their investment is highly secured in the firm. So, they would like to land a
sizable some of the money to this company. So, NAV means net worth divided by the total
number of equity shares and net worth is how much times because it is basically telling
to the firm, to the external stakeholders maybe the new shareholders or to the financial
institutions the intentions of the existing shareholders the intentions and efficiency
of the existing management that intentions of the existing shareholders is that they
are plowing back larger part of the profit into the firm, whatever the returns investment
they had made, whatever the return they are getting now larger extent to larger extent
or larger part of that is being plowed back in the business and by that way the capital
is appreciating, the capital is growing capital is appreciating.
Now, if you have and this is the one important indicator also when the financial institutions
lend money or maybe anybody has to learn to the any source has to lend the money to the
financial to the business undertaking they should also look at this particular indicator
that what part of the profit company has earned and reinvested back in the business. If the
larger part of the profit is reinvested back in the business it means the intention of
the initial shareholders and the management is to grow with the company and to carry on
the business to the commanding heights. But if the largest of the profit is being
grabbed by the existing shareholders and very little amount is being plowed in the company
and for the investment needs the companies looking towards a external sources in that
case you can easily make out the intentions of the company’s shareholders and management
that they do not have the good intentions and to carry on the business for the longer
duration, they would like to they would like to close down the business in the near future.
So, it means the investment made by any external entity is not safe. So, solvency NAV means
net asset value means that what part of the net assets is funded.
For example if you have this balance sheet with us and here you are saying that we have
the paid up capital paid up capital plus free reserves plus free reserves in that case and
total all assets your fixed assets and your current assets if they both are financed from
these 2 sources it means net assets value or the net worth of the company is fully represented
by the share existing shareholders or the existing number of shares in the company and
they have borrowed in a single penny and large chunk of this capital has come by plow plowing
back of the profit by creating and appreciating the free reserves available. It means is a
very good company very solvent company and very good potential institution for the investment,
but if it is the reverse that the net worth is very low major financing of these assets
in the balance sheet is from the external sources you are borrowing the money and everything
in that case company solvency position is not good. So, NAV is the very good indicator
very good ratio which can tell us about that how the company is expected to do in the future,
what is a financial health of the company and how it can do the business; this is the
first ratio in the solvency ratios. . Second ratio is the in the solvency ratios
is the debt equity ratio D E debt equity ratio now what is or what is D
E ratio? Debt equity ratio is debt equity ratio is total debt divided by total equity,
total debt divided by total equity or the paid up capital that is the debt equity ratio
or you call it as the debt equity ratio means total debt when we talk about we talk about
the long term we do not include the short term debt in this ratio long term debt and
total equity that is for you can say that is the total capital, I will not say total
equity it is the total capital debt equity ratio means total capital and then you say
total capital it includes the equity capital and plus preference capital this is the ratio
between the total long term debt and the total equity of the firm.
In other way round if you look at this ratio this is the ratio between the internal funds
and the external funds or you can say that this is the ratio of owned funds and the borrowed
funds. Now see that every company has some borrowing capacity and in the standard as
per the literature available in the financial management this ratio is expected to be 2
is to 1 which is a standard rule of thumb 2 is to 1 when we talk to the previous ratio
that is NAV here you can say there is no standard rule of thumb of interpreting that ratio,
but simple you can say higher the ratio better it is the because in the numerator you have
the net worth. So, higher the network and the lesser number of the equity shares it
means the ratio will be very high. So, higher the ratio better it is and if the ratio is
not that high then it is not good. Similarly, when you talk about the debt equity
ratio the standard rule of thumb of the debt equity ratio is 2:1, it means if you invest
1 rupee debt is 2 means debt and equity is 1. It means if you invest 1 rupee here then
you can expect to borrow 2 rupees from the market if you invest 1 rupee for your own
pocket as a shareholder or as the owner of the company you can expect 2 rupees from the
market that is the ratio of 2:1 that is the ratio of 2 is 1 debt equity ratio. Now for
example, if the total debt component is very high this ratio is for example, 4 is to 1
it means the company has already borrowed a huge amount from the external sources whereas,
their internal investment or the investment internal sources is very very low. In that
case now you see that one indication is that the magnitude of the external funds being
very high as compared to the internal funds it means the company’s over all solvency
position is not good. Second thing is that if for the further expansion
and growth if company want to borrow the funds from the market rather than us being invested
from the pocket by the shareholder then the scope is very very less because they have
already exhausted the borrowing capacity. So, once these 2 things are there in that
case the solvency is indicated by this ratio. So, if this ratio is for example, there is
no external debt now we look at that there is nothing the numerator is 0 that is 0 is
to 1 it means the company has not borrowed even a single penny and an entire funding
is being done from the internal sources it means look at the saved borrowing capacity
of the firm. Saved borrowing capacity of the firm that
how much money they can borrow from the market, so if their own net worth is 2,00,000 rupees
minimum 4, ,00,000 rupees they can borrow from the market and companies capital base
can be taken to the 6,00,000, company’s base can be taken to the 6,00,000, it means
there can be 3 times growth there is a 3 time financial requirement there can be 3 times
growth. So, we have to look at that that what is the debt equity ratio by calculating this
ratio at look at that the firm solvency structural the firm that to what extend the borrowing
capacity has been exhausted by the firm and how much is still left, how much is still
preserved and how much they can expect to borrow more from the market that is one thing.
And if they have fully exhausted then the future scope is limited, but if they have
not exhausted at all future scope is very good and if they have partly exhausted then
yes you can expect that this company can still grow that if this company expects or if they
have to borrow more funds from the market they have to invest their own internal funds
also. So, in that case if the company is a profit making funds they have to stop paying
the dividend and increase the total profit to be reinvested back in the business that
magnitude has to be increased. Or second thing is that if they are expecting, they have to
increase the profitability they have to increase the solvency of the form they have to increase
the net worth of the firm then they can expect a borrowing.
But you see this ratio is only a guiding rule of thumb that is a 2 is to 1 that is a debt
equity ratio should be 2 is to 1, but you see if you analyze a balance sheet of the
company you might see that some company might have the ratios like 4 is to 1, 5 is to 1,
6 is to 1 or sometime 10 is to 1. So, that is not the case that this ratio is not binding
any financial institution to lend to the companies. This company this ratio is not binding if
the lender is assured about that yes his returns are safe and secured or his funds are safe
and secured if it his investment is safe and secured and there is nothing to worry about
the investment then he has not to look for it.
May be possible that the investor is not investing from his own sources, but his borrowing more
from the market and if the lender is convinced that whatever is lending to him his investment
is secure his total funds are secured he is getting good return on investment or his lending
in that case the ratio can go up to ten times you have seen heard about the Vijay Mallya’s
case, you know Vijay Mallya has got lot of money borrowing from the banks and in that
case today when the banks are been asked that how this lending was given 9000 plus crores
who were given by the banks to the a single person or the person of the companies being
large being held by a single person there is no security not at all, even the net worth
was not good his own investment in his own companies was not very high.
At large part of the business was funded by borrowed capital by loans from the financial
institutions and that is largely from the banks. So, you see that today when the banks
are being asked why you lend. So, much of the money when the net worth was not very
high they simply say only on the basis of the brand name. Kingfisher brand name on the
basis of that they have lent huge amount of the money to the companies of Vijay Mallya
and today their brand name when they had it is a flop show and it has not worked well
in the market, now there is no security there is no say you can call it as a collateral
taken no security is taken, now the funds are at the risk and almost see that they are
almost the larger part of the funds will become the bad debts.
So, that debt equity ratio means it tells about what is the borrowing capacity of the
firm what part of the borrowing capacity has been utilized by the firm what part is left
to be utilized and how they can expect to further borrow the money from the market and
normal rule of thumb for this ratio is 2 is to 1, but it can be more than also if the
lender is assured of proper returns, better returns, effective returns from the company
in which the investment is being made by the lenders.
. Then is the next ratio we are going to talk
is 2 more ratio we are going to talk about here is that is one is the ICR interest coverage
ratio and then second I will be talk about after this is the debt service coverage ratio.
Interest coverage ratio when we talk about we take care that is the numerator is profit
after tax plus interest on long term debt, interest on long term debt plus noncash charges
and divided by the interest on the long term debt interest on long term debt, interest
on long term debt that plus noncash charges plus interest on the long term loans. This
ratio is going to tell us about the interest paying capacity of the firm, how much interest
the firm is going to pay because for pay the interests it is a revenue expense.
And for the paying the interest on any loan borrowed by the company you must have the
liquid resources and the liquidity comes number one from the profit if it is a cash profit
larger part. Second thing is you have to first add back the interest which is already paid.
So, that if it is not paid then that money is also available plus that depreciation fund
noncash charges like depreciation fund that sometime if you do not have the cash ability
of the profit sufficient profits are not available or the profits are there, but cash profits
are not there then the depreciation fund can be used to link with normally for the short
duration and then we convert that normal profit into the cash profit then the depreciation
fund can be replenished back. So, how many times the total liquidity liquid
funds are available with the firm as against the total interest component that industry
the company has to pay maybe monthly rent six monthly rent or quarterly sorry say monthly
interest six monthly interest quarterly interest or yearend interest once in a year like that.
So, in that case the; it is talking about the interesting paying capacity of the firm.
Interest paying capacity of the firm is high then still you can expect to borrow more money
off from the market because the solvency structure it is very good, but if the interest paying
capacity is not high in that case they cannot expect to borrow more from the market and
in that case their borrowing capacity will be reducing.
So, it means what should be the ratio as high as possible there is standard rule of thumb,
but it should be minimum 2 to 3 times of the denominator and if it is more than that is
really very good, but it should be really high to the extent it is possible. And one
more will be talking under which category that is a debt service coverage ratio in this
we include we keep everything same, but in the denominator be add one more thing is that
the installment of the principle to be paid installment of the principal to be paid installment
of the principal to be paid, that is interest on long term debt, interest on long term debt
plus installment on principal. So, here then we return the loan taken in
any particular year we return 2 things one we return the interest on the loan and second
we returned the installment of the principles. So, interest maybe the monthly payment installment
maybe the six monthly or once in a year or quarterly. So, in this case also now we increase
the this is the ratio that is the pat plus interest on long term debts plus noncash charges
this is a numerator which will remain the same in both the ratios, but the denominator
will be changed. . And in case of the DSCR, we will add in the
interest on the long term debt we will add the interest on this installment of the principal
part also and then we see that how much is a we are going to pay how much is due on account
of the loan to be serviced back and how much cash is available, how much liquidity is available
with the firm. And again the ratio should be as high as possible as big as possible
because higher the liquidity is better for the financial institutions because they can
expect that the form will never default and the reforms will be or the return and the
interest on the loan will be paid back on time principal will also be coming back on
the time their funds are safe and secured and this is ultimate objective of any financial
institutions that their lending should be save and their lending or their loan should
be growing that should be earning the good rate of the interest also.
So, these are the 4 ratios which we have discussed in the solvency category and then we will
be talking about the other ratios and then we will discuss a case in which we will calculate
all the ratios interpret them about that company and tried find out about the financial health
of that company and that all I will discuss in my next lectures.
Thank you.