Which ratio indicates the firm's capacity to pay long-term debts and procure additional loans and informs whether the firm is following the policy of trading on equity ?

Question

Accepted Answer

The correct option is 2:
The Debt-Equity Ratio is the single most appropriate measure because it directly addresses all the elements mentioned in the question. This ratio is calculated as Total External Liabilities (Debt) divided by Shareholders' Funds (Equity). It is a crucial measure of a firm's long-term financial solvency and is also known as a leverage ratio. The ratio indicates the relative proportion of funds contributed by creditors versus owners, which directly reveals the firm's capital structure and its capacity to procure *additional* loans. Lenders prefer a lower ratio as it provides a larger safety margin and a lower risk profile. Furthermore, the ratio explicitly captures the concept of "trading on equity," as a higher proportion of debt (a high ratio) is the definition of using financial leverage to magnify the return on shareholder equity.

The incorrect option is 1:
The Proprietary Ratio, calculated as Shareholders’ Funds / Total Assets, is a key solvency ratio but focuses on the proportion of total assets financed by the owners' capital. While a high ratio indicates a sound financial structure and good creditworthiness, it does not explicitly compare debt to equity. It is a measure of the *source* of asset financing, not the *relationship* between debt and equity, and is not the primary metric used to analyze "trading on equity."

The incorrect option is 3:
Return on Shareholder's Funds (or Return on Equity) is a profitability ratio, calculated as Net Profit / Shareholders’ Funds. Its sole purpose is to measure the efficiency with which a firm uses the owner's investment to generate profit. Crucially, it is not a solvency ratio; therefore, it provides no direct information about the firm's capacity to pay its long-term debts or its ability to secure new loans, which are questions of capital structure and solvency.

The incorrect option is 4:
The Debt-Service Ratio is a coverage ratio used to assess a firm's ability to meet its *current* debt obligations, specifically principal and interest payments, from its cash flow or operating earnings. While it is certainly related to a firm’s capacity to pay debt, it is a flow-based ratio that measures *coverage* (servicing the debt) and is not a capital structure ratio. It does not reflect the overall long-term mix of debt and equity on the balance sheet, which is the necessary information to inform the policy of trading on equity.