Solvency Ratios: Debt-Equity, Proprietary & Interest Coverage — CBSE Class 12 Accountancy

While liquidity ratios ask "Can the company pay its bills this month?", solvency ratios ask a bigger question: "Is this company financially sustainable for the long term?"

These ratios matter most to long-term lenders and investors — and they matter to you because they carry significant marks in both CBSE board exams and CA Foundation. This post covers all three solvency ratios you need to know, with full worked examples and the interpretation language examiners reward.

Ratio 1: Debt-Equity Ratio

\text{Debt-Equity Ratio} = \frac{\text{Long-term Debts}}{\text{Shareholders' Funds}}

Ideal value: ≤ 2:1

Components

Long-term Debts include:

Debentures
Long-term bank loans
Bonds payable
Mortgage loans

Do not include bank overdraft or short-term borrowings — these are current liabilities.

Shareholders' Funds include:

\text{Shareholders' Funds} = \text{Equity Share Capital} + \text{Preference Share Capital} + \text{Reserves \& Surplus} - \text{Accumulated Losses}

Exam trap: Students often forget to subtract accumulated losses (debit balance in Profit & Loss Account) when calculating Shareholders' Funds. Always check.

Worked Example

Long-term Debts = ₹4,00,000 | Shareholders' Funds = ₹6,00,000

\text{Debt-Equity Ratio} = \frac{4{,}00{,}000}{6{,}00{,}000} = \mathbf{0.67:1}

Interpretation: For every ₹1 of owners' funds, the company owes only ₹0.67 to long-term lenders. This is well within the ideal threshold — the company has a low-risk capital structure.

Reading the Ratio

D/E Ratio	What It Signals
< 1:1	Conservative — equity-heavy, low financial risk
1–2:1	Balanced — acceptable leverage
2:1	High leverage — greater risk for lenders and shareholders
Very low (near 0)	May indicate underutilisation of debt financing

Key insight: A lower ratio is generally safer for creditors. But an extremely low ratio may suggest the company is not using debt financing efficiently to grow.

Ratio 2: Proprietary Ratio

\text{Proprietary Ratio} = \frac{\text{Shareholders' Funds}}{\text{Total Assets}}

Ideal value: > 0.5 (or > 50%)

What It Shows

This ratio reveals what proportion of total assets is financed by the owners themselves, as opposed to borrowed funds. The higher the ratio, the less dependent the company is on external creditors.

Components

Total Assets = All fixed assets + All current assets (i.e., everything on the assets side of the balance sheet)

Shareholders' Funds = Same as in Debt-Equity Ratio above.

Worked Example

Shareholders' Funds = ₹6,00,000 | Total Assets = ₹10,00,000

\text{Proprietary Ratio} = \frac{6{,}00{,}000}{10{,}00{,}000} = \mathbf{0.6 \text{ or } 60\%}

Interpretation: 60% of total assets are financed by the owners — a strong financial position that indicates low dependence on external debt.

Relationship with Debt-Equity Ratio

The Proprietary Ratio and Debt-Equity Ratio tell the same story from opposite angles:

High Proprietary Ratio → Low Debt-Equity Ratio → Lower financial risk
Low Proprietary Ratio → High Debt-Equity Ratio → Higher financial risk

If you've calculated one correctly, use it as a sense-check for the other.

Ratio 3: Interest Coverage Ratio

\text{Interest Coverage Ratio} = \frac{\text{EBIT}}{\text{Interest on Long-term Debts}}

Where EBIT = Earnings Before Interest and Tax (also called Operating Profit)

Ideal value: > 3 times

What It Shows

This ratio tells lenders how comfortably the company can service its interest obligations from its operating profit. A ratio of 5, for example, means the company earns enough operating profit to pay its interest bill five times over — giving lenders significant confidence.

Why EBIT (Not Net Profit)?

Interest is paid before tax is calculated — so the relevant earnings figure is profit before both interest and tax are deducted. Using net profit (after interest and tax) would understate the company's true ability to cover interest.

Worked Example

EBIT = ₹1,50,000 | Annual Interest on Long-term Debts = ₹30,000

\text{Interest Coverage} = \frac{1{,}50{,}000}{30{,}000} = \mathbf{5 \text{ times}}

Interpretation: The company earns 5 times its interest obligation from operating profit — very safe for lenders.

Reading the Ratio

Interest Coverage	What It Signals
5 times	Excellent — very low default risk
3–5 times	Comfortable — within ideal range
1.5–3 times	Adequate but under watch
< 1.5 times	Danger — operating profit barely covers interest
< 1 time	Critical — company cannot cover interest from operations

The Three Solvency Ratios at a Glance

Ratio	Formula	Ideal	What It Measures
Debt-Equity	Long-term Debts ÷ Shareholders' Funds	≤ 2:1	Balance between borrowed and owned capital
Proprietary	Shareholders' Funds ÷ Total Assets	0.5	Owner-financed proportion of total assets
Interest Coverage	EBIT ÷ Interest on LT Debts	3 times	Ability to service debt interest from operations

Common Mistakes in Solvency Ratios

Mistake	Fix
Including bank overdraft in long-term debts	Bank overdraft is a current liability — exclude from D/E ratio
Forgetting to subtract accumulated losses from Shareholders' Funds	Debit balance in P&L A/c reduces Shareholders' Funds
Using net profit instead of EBIT for Interest Coverage	Always use EBIT — profit before interest and tax
Confusing Total Assets with Net Assets	Total Assets = Fixed + Current Assets (gross, before deducting liabilities)

What's Next?

In Part 3, we move to Activity (Turnover) Ratios and Profitability Ratios — including Inventory Turnover, Receivables Turnover, Gross Profit Ratio, Net Profit Ratio, and Return on Investment — with the key rules on when to use averages, and how to interpret each ratio correctly.

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