Different tools and methods are adopted to access and analyze the profitability and financial standing of a business. Mainly the financial statements are studied to determine the financial position of a company. These financial statements of the company are analyzed using different tools and methods. Ratio analysis is one such method which is widely used to analyze the financial statements of a company. Proprietary ratio is a part of ratio analysis. Before moving further, let us know first, what is the ratio analysis?
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What is the Ratio Analysis?
Ratio analysis is a quantitative method which is used to determine the profitability financial position of a company. The financial statements of the company such as balance sheet and income statement of the company are analyzed using the different ratio which are part of the ratio analysis. Profitability analysis is one such ratio used for this purpose.
What is the Proprietary Ratio?
Proprietary ratio simply tells us how efficiently a company can generate profits from its operations. In other words, this ratio is used to determine the relationship between the amount invested by the proprietors in the total assets of the company. In simple terms, you can say that the proprietary ratio is the percentage of assets funded by the shareholders of the company.
Significance of the Proprietary Ratio
A high proprietary ratio is the indicator of sound financial health of a business because it means that the equity of the company is being used to acquire the large proportion of the total assets of the company. It also tells us that the company is less dependent on the external financial sources and is in the less risk zone as it can utilize its own assets in case of any unforeseen situations. On the other hand, a low proprietary ratio indicates that the company does not have sufficient funds to support the unforeseen risks and at that time it will have to depend on unsecured loans which may destabilize the company’s financial position. A high proprietary ratio is therefore a desirable parameter for the investors also before taking investment decisions in a particular business.
The lenders also use this ratio because it helps them understanding the risk before giving any loan to the company. It the proprietary ratio is high, then it enhances the confidence of the creditor and the company may be able to secure ease and cheap loans whenever required. In financial crisis, the chances of the company going bankrupt, reduce significantly for the companies having high proprietary ratio.
However, it is not the case that high proprietary ratio is always good and low proprietary ratio is always bad. The interpretation of the proprietary ratio also depends upon several other factors, some of which are discussed below:
Risk Appetite
The risk appetite of the investor also derives the ideal value of the proprietary ratio. If the investor is willing to take high risk, then a lower proprietary ratio is preferred. This is due to the reason that the more debt means more leverage and there may be high profits due to this. However, if the investor wants to play safe then the low proprietary ratio is good because less leverage means the shareholders will get stable returns.
Type of Business
A business has to face many risks, some of which are external risks like market risks and some are internal risks. If the external risks are high, then the company should avoid taking aggressive financing and should try to keep its proprietary ratio high. On the other hand, if the external risks are less than the company may afford leverage more loans. In this case, keeping the proprietary ratio low would be appropriate.
Growth Stage of the Company
The ideal value of proprietary ratio also depends on the growth stage of the company. At the early stages of their journey, most companies require more capital. They may be dependent on external financing at this stage. Therefore, a low proprietary ratio at this stage is appropriate. However, at the mature stage, when the firm have achieved more profitability position, the shareholders should try to invest in more assets and to keep the proprietary ratio high to secure a safe position.
How to Calculate the Proprietary Ratio?
Before we learn how to calculate the proprietary ratio, we must understand what are proprietor’s fund and total assets first.
Proprietor’s Fund
The proprietor’s fund is the amount invested by the shareholders/owners in the business. It is also called share capital. There are two types of share capitals, equity share capital and preferential share capital and it is written on the right side of the Balance sheet under the heading ‘Equity’.
Total Assets
It comprises of all type of assets owned by the company, such as, fixed assets (tangible and intangible), current assets, deferred revenue expanses etc.
Proprietor’s fund= Equity Share Capital + Preference Share Capital + Reserves and Surplus (Excluding fictitious Assets) + Money received against share warrants
Total Assets= Current Assets + Non- Current Assets (including deferred revenue expenses)
Example 1:
Given below is the balance sheet of XYZ Pvt. Ltd. Calculate the proprietary ratio of the company by using the data given in the balance sheet.
Balance Sheet of XYZ Pvt. Ltd:
| Particulars | Amount (in Rs.) |
| Equity and Liabilities Shareholder’s Fund: | |
| Share Capital | 12,50,000 |
| Reserves and Surplus | 7,25,000 |
| Money received against share warrants | 5,35,000 |
| Profit as per income statement | 5,50,000 |
| Non-Current Liabilities: | |
| 15% Debentures | 2,25,000 |
| Bank Loan | 15,85,000 |
| Long- term Provisions | 9,25,000 |
| Current Liabilities: | |
| Trade Payables | 35,000 |
| Provision for Tax | 65,000 |
| 58,95,000 | |
| Assets Non-Current Assets | |
| Land and Building | 9,15,000 |
| Plant and Machinery | 32,00,000 |
| Goodwill | 5,00,000 |
| Investments | 2,25,000 |
| Current Assets | |
| Inventory | 5,75,000 |
| Debtors 2,00,000 Less: Provision (10,000) | |
| Prepaid Expenses | 3,25,000 |
| Cash and Bank | 1,55,000 |
| 58,95,000 |
Proprietors’ Funds = Share Capital + Reserves and Surplus + Money received against share warrants + Profit as per Income Statement
= 12,50,000+7,25,000+5,35,000+5,50,000= 30,60,000
Total Assets= 58,95,000
= 0.52:1 (or 52%)
Example 2:
Calculate the proprietary ratio of the company ABC. Pvt. Ltd, using the following information:
Fixed assets of the company= ₹15,00,000
Working Capital= ₹6,27,000
Current Liabilities= ₹2,20,000
Solution:
Proprietors’ Funds = Fixed Assets + Working Capital
=₹15,00,000+₹6,27,000= ₹21,27,000
Working Capital= Current Assets – Current Liabilities
Current Assets= Working Capital + Current Liabilities
=₹6,27,000 + ₹2,20,000= ₹8,47,000
Total Assets= Fixed Assets + Current Assets
=₹15,00,000 + ₹8,47,000 = ₹23,47,000
= 0.91:1 = 91%
Conclusion
Proprietary Ratio is one of the components of ratio analysis and is used to assess the financial position of a company. In brief, you can say that the proprietary ratio is the percentage of assets funded by the shareholders of the company. A high proprietary ratio is the indicator of sound financial health of a business because it means that the equity of the company is being used to acquire the large proportion of the total assets of the company. It also tells us that the company is less dependent on the external financial sources and is in the less risk zone as it can utilize its own assets in case of any unforeseen situations. On the other hand, a low proprietary ratio indicates that the company does not have sufficient funds to support the unforeseen risks and at that time it will have to depend on unsecured loans which may destabilize the company’s financial position. The proprietary ratio is therefore a crucial parameter for investors to take any investment decision in the company. Although, a high proprietary ratio is preferred by the investors as it indicates the strong financial position of the company, however it is not always the case. The ideal value of the proprietary ratio also depends on several other factors also such as type of business, risk appetite of the investors, growth stage of the company, etc. The investors therefore should interpret the proprietary ratio of a company keeping these factors in mind.
Read more: Inventory Turnover Ratio: Examples and Importance
