1.4 Query
Computation of Debt-Equity Ratio
1. A company is engaged in manufacture, repair and overhaul of aircraft helicopters and other related items. The main customer of the company is the Indian Air Force. The products manufactured are both under licence from foreign countries and based on indigenous technology. Deferred payment terms are available in respect of supplies effected by USSR for the manufacture of aircraft under licence from USSR. The deferred payment terms are spread-over a period of 10/15 years in respect of supplies and 45 years in respect of liabilities arising on account of any change in the manner of computing Rupee-Rouble Exchange pursuant to agreement between USSR and the Indian Government. This funding facility extended by the USSR is extended to the company’s main customer viz. IAF. Deferred debts represent the credit given to the customer in respect of material cost in the sales set-up and for which payments are due to USSR.
2. In computing debt-equity ratio, the company takes into account only the paid-up capital as equity and Government of India loans as debt excluding deferred liabilities (Schedule – 4 of Balance Sheet). The workings for 1985-86 are given in Annexure-I. This is reflected in the Directors’ Report. However, the Comptroller & Auditor General of India is including deferred liabilities as part of the debt for computing debt-equity ratio. Their method of working is shown in Annexure – II.
3. The company is of the opinion that the deferred payment liabilities, in isolation, cannot be taken as the long-term debt. These have to be netted with the deferred debts extended to the customer, as otherwise, proper reflection of liability on account of USSR credit will not be made. The debt-equity ratio worked out in accordance with this view is indicated in Annexure – III. In the revised working suggested by the company, reserves & surplus, along with paid-up equity and net deferred liabilities (deferred liability reduced by deferred debts) along with other debts excluding public deposits, have been taken.
4. The querist has sought the opinion of the Expert Advisory Committee as to which is the correct method of working out debt-equity ratio in the circumstances explained above?
Opinion December 3, 1987
1. The Committee notes that there are different methods of calculating debt-equity ratio depending upon the objective which the ratio is expected to serve. For instance, Eric L. Kohler, in his ‘A Dictionary for Accountants’ (5th Ed.) has defined debt-equity ratio as below:
“1. Long-term debt divided by Stockholders’ equity (net worth): the customary meaning of the term as viewed by market analysts.
2. The amount owing to outsiders divided by stockholders’ equity (net worth)”
2. The Committee also notes that the Canadian Institute of Chartered Accountants, in their ‘Terminology For Accountants’(3rd Ed.), have defined ‘debt-equity ratio’ as “1. Any ratio expressing a relationship between debt and shareholders’ equity. 2. The ratio of long-term debt to the sum of long-term debt and shareholders’ equity.”
3. The Committee is of the view that, in the context of the query, the first definition given by Kohler, viz., “Long-term debt divided by Stockholders’ equity (net worth)” appears to be appropriate.
4. With regard to the constituents of long-term debt and equity, the Committee notes as below:
(a) Long-term debt
(i) Terms Used in Financial Statements (ICAI): “Liability which does not fall due for payment in a relatively short period, i.e., normally a period not more than twelve months.”
(ii) Kohler: “(on balance sheet date) Debt due after one year”. (‘deferred liability’ has been defined by Kohler as “any long-term liability”)
(iii) Capital Issues Exemption Order, 1969: “debt includes all borrowings repayable not earlier than five years from the date of borrowing (whether debentures, loans or deferred payment including interest thereon for the purchase of capital equipment) and preference shares redeemable not later than 12 years from the date of issue”.
(b) Equity
(i) Kohler: “………: 2. An interest in property or in a business, subject to claims of creditors: equity ownership. Total equity is an equivalent British term.
(ii) Terminology for Accountants – Canadian Institute of Chartered Accountants: “1. The claim or right of proprietors or creditors to the assets of a business 2. The residual interest of an owner or a shareholder.”
(iii) Capital Issues Exemption Order, 1969 – “equity includes paid-up equity share capital, share premium, free reserves, irredeemable preference shares and preference shares redeemable not earlier than twelve years from the date of issue.”
4. On the basis of the above, the Committee is of the opinion that in the circumstances of the query, ‘equity’ should include ‘paid-up equity share capital’ and reserves and surplus and debt should include public deposits and deferred payment liabilities. The Committee is further of the opinion that deferred payment liabilities should not be netted-off with deferred debts, since the purpose of computing debt- equity ratio is to evaluate the capital structure or the funding pattern in an enterprise irrespective of the facts how the funds have been invested.
ANNEXURE - I
DEBT : EQUITY RATIO IS 1.49 : 1
ANNEXURE – II
DEBT : EQUITY IS 10.61 : 1
ANNEXURE – III
DEBT: EQUITY RATIO IS 2.11: 1
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