The Proprietary Ratio is a solvency ratio that measures the proportion of shareholders’ funds to total assets of a business. It indicates the extent to which the company’s assets are financed by the owners rather than by external liabilities. A higher proprietary ratio reflects greater financial stability, lower financial risk, and stronger long term solvency, while a lower ratio indicates greater dependence on borrowed funds. This ratio is useful for investors, creditors, and management in assessing the financial strength and capital structure of the business. It helps evaluate the safety of creditors’ funds and the overall financial soundness of the organization.
1. Proprietary Ratio (Equity Ratio)
Formula: Shareholders’ Funds ÷ Total Assets
(Where Shareholders’ Funds = Equity Share Capital + Reserves & Surplus – Fictitious Assets; Total Assets = Fixed Assets + Current Assets – Fictitious Assets)
This ratio measures the proportion of total assets financed by owners’ funds (equity). A high ratio (say, >60%) indicates strong financial stability, lower dependence on external debt, and greater safety for creditors – but may also suggest conservative management not leveraging borrowed funds for growth. A low ratio signals heavy reliance on debt, which increases financial risk and interest burden. There is no universal ideal; manufacturing companies may have lower ratios due to heavy borrowings, while service firms prefer higher ratios. It is a key indicator of long-term solvency and capital structure strength.
2. Debt–Equity Ratio
Formula: Total Debt (Long-Term Liabilities) ÷ Shareholders’ Funds
(Sometimes includes preference share capital as debt)
This ratio compares external debt with internal owner funds. A low ratio (e.g., 1:1 or lower) indicates a safer capital structure with less financial risk – creditors are more confident in lending. A high ratio (e.g., 3:1) signals aggressive financing, high interest costs, and greater vulnerability during downturns – but may yield higher EPS through trading on equity if returns exceed interest cost. The ideal varies by industry; capital-intensive sectors (steel, infrastructure) tolerate higher ratios. A healthy balance ensures adequate gearing without overleveraging, protecting both shareholder returns and creditor security.
3. Interest Coverage Ratio
Formula: Earnings Before Interest and Tax (EBIT) ÷ Interest Expense
(Also known as Debt Service Coverage Ratio – simplified version)
This ratio measures how many times a company can cover its interest obligations from operating profits. A higher ratio (say, 5× or more) indicates strong profitability and comfortable capacity to pay interest – reducing the risk of default and reassuring lenders. A ratio below 2× is a warning sign, as it leaves little margin for profit fluctuations or interest rate hikes. A ratio below 1× means the company is not generating enough profits to cover even its interest – a critical red flag. This is a crucial liquidity-cum-solvency metric for creditors while sanctioning loans.
4. Capital Gearing Ratio
Formula: Fixed Interest/Dividend Bearing Funds ÷ Equity Shareholders’ Funds
(Where Fixed Bearing Funds = Long-Term Debt + Preference Share Capital; Equity Funds = Equity Share Capital + Reserves & Surplus)
This ratio differentiates between funds with fixed obligations (interest/dividend) and residual owner funds. High gearing means more fixed-cost capital – beneficial in good times (trading on equity) but risky in bad times due to mandatory payments. Low gearing means lower financial risk but also lower potential returns. A ratio of 1:1 is often considered balanced. High gearing is favourable when ROCE exceeds interest rate; otherwise it erodes shareholder value. This ratio helps in long-term capital planning and deciding optimal mix of equity vs. preference/debt funding.
