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Debt

Equity Ratio

Long term Debt

Shareholders Funds

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Total Debt to Equity Ratio

Long-term Debt + Short-term Liabilities

Shareholders Funds

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Debt to Net Worth Ratio

Long term Debt

Net worth

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Interest Cover and Income Gearing

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Interest Cover

Profit Before Interest and Tax

Interest charges

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Income GearingThe inverse of interest cover is called income gearing;indicating the proportion of pre-tax earningscommitted to prior interest charges.

Interest Charges X 100

Profit Before Interest and Tax

The lower the percentage indicates the companys ability

to meet interest obligation in time.

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ILLUSTRATION 6.5Nataraj Paper Ltds balance sheet shows the following

structure of finance for the year ended 31stMarch, 2009. Rs. Lakhs)

Equity share capital (5,00,000 share of Rs. 10 each) 50

Preference share capital (12%) (10,000 shares of Rs. 100 each) 10Share premium 20

General reserve 15

Non-convertible debentures(14%) ( fully secured) 40

Current liabilities 5

Total assets 140

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The profit earned during the year before interestpayments and tax (@ 40%) amounted to Rs. 34 lakhs

Board of Directors recommend a dividend @ 18% onequity shares.

You are required to calculate : (a) Capital gearing ratio,(b) Income gearing ratio.

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SolutionAdjustments to be made to the Profit before Interest and Tax (Rs. lakhs)

Profit before interest and tax 34.00

Less: Debenture interest (Rs. 40,00,000x 14/100) 5.60

28.40Less: Corporate tax ( @ 40%) 11.36

Profit after interest and tax 17.04

Less: Preference dividend ( Rs. 10,00,000 x 12/100) 1.20

Profit available for equity holders 15.84

Less: Dividend on equity capital ( @ 18%) 9.00Retained Profit 6.84

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(a) Capital Gearing Ratio

= Long-term debt + Preference capital X 100

Long-term debt + Preference capital + Equity capital + Reserves

= 40 + 10 x 100 = 50 x 100 = 37.04%

40 + 10 + 50 + 20 + 15 135

The gearing ratio is small and the companys

financial risk is lesser.

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(b) Income Gearing Ratio

= Profit before interest and tax = 34 = 6.07 times

Interest payments to debenture holders 5.60

This shows sufficient cushion for payment ofinterest to the debenture holders.

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Practical Problems Problem 6.1XYZ Ltd. had the following Balance sheet for the year ended 31st March, 2009 (Rs. lakhs)

Liabilities Assets

Equity capital 10 Fixed assets (net) 25

(one lakh shares of Rs. 10 each) Current assets 15

Reserve and surplus 2

15% Debenture 20

Current liabilities 8

40 40

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Additional information given :Fixed costs per annum ( excluding interest ) Rs. 8 lakhsVariable operating cost ratio 80%

Total asset turnover 3

Incometax 50%

Required (i) Earnings per share,(ii) Operating leverage, (iii) Financial leverage,

(iv) Combined leverage, (v) Current ratio.

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Solution(i) Total assets = Rs. 40 lakhsTotal asset turnover = 3Total sales = Rs. 120 lakhs

(Rs. lakhs)

Sales 120Variable cost (@ 80%) 96Contribution 24Less: Fixed costs 8Net Profit ( EBIT) 16

Less : Interest on debentures 3Profit before tax ( PBT) 13Tax @ 50% 6.50PAT 6.50

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Earnings Per Share = Rs. 6,50,000 = 6.50 per share

1,00,000 shares

(ii)Operating Leverage = Contribution = 24 = 1.5

EBIT16

(iii)Financial Leverage = EBIT = 16 = 1.23

PBT 13

(iv)Combined Leverage = Contribution X EBIT = 1.5 X 1.23 = 1.85

EBIT PBT

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Problem 6.2The following are the operating results of a firm:Sales ( units) 25,000Interest per annum Rs. 30,000

Selling price per unit Rs. 24Tax rate 50%Variable cost per unit Rs. 16

No. of equity shares 10,000Fixed costs per annum Rs. 80,000

Compute(1) Break even sales (2) Earnings before interest and tax(3) Earnings per share (4) Operating leverage (5) Financialleverage.

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SolutionIncome Statement (Rs.)

Sales (25,000 units @ Rs. 24) 6,00,000Less: Variable cost @ Rs. 16 p.u. 4,00,000

Contribution 2,00,000

Less: Fixed cost 80,000

EBIT 1,20,000

Less: Interest 30,000

EBT 90,000

Less: Tax@ 50% 45,000

EAT 45,000

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(1) Break- even Sales = Fixed cost = 80,000 = 10,000 units

Contribution p.u. 8

(2) EBIT = Rs. 1,20,000

(3) Earnings Per Share = EAT = Rs.45,000 = Rs.4.50

No. of equity shares 10,000

(4) Operating Leverage = Contribution = 2,00,000 = 1.67

EBIT 1,20,000

(5) Financial Leverage = EBIT = 1,20,000 = 1.33

EBIT 90,000

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Problem 6.3Prepare the income statement of a firm which gives the

following details relating to its operations:

Operating leverage 4

Financial leverage 2

Annual interest paid Rs. 10 lakhs

Contribution / sales 0.4

Tax rate 40%

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SolutionFinancial Leverage = ( given)

Financial Leverage = EBIT

EBIT- Interest2 = EBIT

EBIT Rs. 10,00,000

EBIT = Rs. 20,00,000

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Operating Leverage = 4 ( given)

Operating Leverage = Contribution

EBIT

4 = Contribution

Rs. 20,00,000

Contribution = Rs. 80,00,000

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Operating Leverage = Contribution

Contribution Fixed cost4 = Rs. 80,00,000

Rs. 80,00,000 Fixed cost

Fixed cost = Rs. 60,00,000Contribution = 0.40

Sales

Rs. 80,00,000 = 0.40

Sales

Sales = Rs. 2,00,00,000

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Income Statement (Rs.)

Sales 2,00,00,000Less: Variable cost (@ 60%) 1,20,00,000

Contribution 80,00,000

Less: Fixed cost 60,00,000

EBIT 20,00,000

Less: Interest 10,00,000

EBT 10,00,000

Less: Tax @ 40% 4,00,000

EAT 6,00,000