Which among the following is a long-term solvency ratio ?

Question

Accepted Answer

The correct option is 2:
The Proprietory Ratio is correctly identified as a long-term solvency ratio. Solvency ratios are crucial metrics designed to evaluate a company's financial health, specifically its ability to meet all its obligations that mature over a long period. This ratio is calculated by dividing Proprietors' Funds (Shareholders' Equity) by Total Assets. It is a direct measure of the owners' contribution to the total capital employed in the business. A high proprietory ratio signifies that a major portion of the firm's assets is financed by the owners, rather than external borrowings, which assures long-term creditors of a substantial safety margin and demonstrates a robust, stable financial structure.

The incorrect option is 1:
The Earnings per Share (EPS) ratio is classified as a profitability ratio and is particularly important from a shareholder's perspective. It measures the net income earned per outstanding share of common stock. Its primary focus is on the return generated for equity shareholders and is used to evaluate investment potential and profitability. Although profitability contributes to overall financial health, EPS does not directly measure the firm's structural capacity to meet its long-term liabilities, which is the function of a solvency ratio.

The incorrect option is 3:
The Gross Profit Ratio is a fundamental profitability ratio that assesses the efficiency of a company's production or trading activities. It is computed as Gross Profit divided by Net Sales and indicates the percentage of sales revenue remaining after deducting the cost of goods sold. While essential for analyzing operational efficiency, this ratio focuses purely on income statement elements for a specific period. It is not designed to analyze the long-term composition of capital or the firm's ability to cover its debt, which are the domain of solvency ratios.

The incorrect option is 4:
The Capital Turnover Ratio, often interpreted as the Total Asset Turnover Ratio, belongs to the category of turnover or activity ratios. This ratio measures the efficiency with which a company uses its total assets (or capital employed) to generate sales revenue. It shows the speed at which assets are being turned over into sales. As an efficiency measure, it focuses on the utilization of resources to generate sales, a different purpose entirely from solvency ratios, which are specifically concerned with the firm's long-term debt-paying capacity.