How to Calculate Proprietary Ratio with Example and Interpretation
The proprietary ratio is a fundamental concept in accounting, especially when evaluating a company's financial structure and solvency. It helps students and stakeholders understand the proportion of total assets financed by shareholders' (or proprietors') funds as opposed to external debt. This insight is important for making informed decisions regarding investment, lending, and overall financial health analysis.
Meaning of Proprietary Ratio
The proprietary ratio measures how much of a company’s total assets are funded through the owners’ equity, rather than by borrowing. It gives valuable information about a business’s reliance on equity versus debt. If the ratio is high, it suggests stronger financial stability and less dependence on creditors.
A favorable proprietary ratio is considered to be 0.5 or higher—indicating that proprietors’ funds account for at least 50% of total assets. This gives investors and creditors confidence in the company’s capacity to manage obligations and sustain operations in the long run.
Formula for Proprietary Ratio
To compute the proprietary ratio, use the following formula:
Where:
- Proprietors’ Funds include equity share capital, preference share capital, reserves, and surplus.
- Total Assets refer to all assets owned by the company such as fixed assets, current assets, investments, and others.
Example: Step-by-Step Calculation
Suppose a business has the following figures:
- Equity share capital: $50,000
- Reserves: $30,000
- Total assets: $100,000
Step 1: Add the equity and reserves to find proprietors' funds.
Step 2: Use the formula to calculate the ratio.
Interpretation: 80% of the company’s assets are funded by the proprietors, showing strong financial independence and low reliance on external financing.
| Step | Action |
|---|---|
| 1 | Add equity share capital and reserves to find proprietors' funds. |
| 2 | Sum up all assets listed in the balance sheet to get total assets. |
| 3 | Divide proprietors' funds by total assets. |
| 4 | Express the answer as a proportion or percentage for final interpretation. |
Interpretation and Application
The proprietary ratio is primarily a solvency ratio. If the value is high, it means a greater share of company assets is funded by equity, reflecting solid financial grounding and making a positive impression on investors and creditors.
A ratio below 0.5 often indicates higher reliance on debt, which could increase risk, interest costs, and possibly reduce profitability. Investors and lenders may view such companies as higher risk, leading to challenges in securing affordable financing.
However, some industries, especially capital-intensive ones, may require more external funds even if profitability remains strong. Therefore, use this ratio alongside other financial indicators for a complete analysis.
| Ratio | Formula | Indicates |
|---|---|---|
| Proprietary Ratio | Proprietors’ Funds / Total Assets | Owners’ stake in total assets |
| Debt-Equity Ratio | Total Debt / Proprietors’ Funds | Proportion of debt to equity |
Key factors to remember:
- A high proprietary ratio increases trust among lenders and may help secure funds on better terms.
- A low ratio can signal a riskier business and may result in higher borrowing costs or stricter loan conditions.
- The optimal level of this ratio can differ depending on industry standards and the company’s growth phase.
Tips for Students
- Always check which items belong in proprietors’ funds (include all reserves & surplus and capital, but don’t include outsider liabilities).
- Be careful with asset figures—ensure only company-owned assets are included.
- Practice calculating with actual balance sheet examples for deeper understanding.
Vedantu Resources and Next Steps
To strengthen your mastery on accounting ratios, access the following relevant Vedantu resources and practice questions. These will help you solidify concepts and perform better in Commerce assessments:
- Accounting Ratios: Concepts and Examples
- Practice worksheets and live doubt sessions on the Vedantu learning portal
Understanding the proprietary ratio brings you clarity in analyzing financial statements and helps you stand out in Commerce studies.
FAQs on Proprietary Ratio in Commerce: Definition, Formula & Examples
1. What is the proprietary ratio?
The proprietary ratio is a solvency ratio that measures the proportion of a company's total assets financed by its proprietors' funds (shareholders’ equity). It indicates the financial strength and long-term stability of the company by showing how much of the assets are owned by shareholders rather than financed by external debt. A higher proprietary ratio reflects greater financial stability and lower risk for creditors.
2. What is the formula for proprietary ratio?
The formula for the proprietary ratio is:
Proprietary Ratio = Proprietors’ Funds / Total Assets
Where Proprietors’ Funds = Equity Share Capital + Reserves & Surplus – Fictitious Assets.
Total Assets = All assets from the balance sheet, including both current and non-current assets.
3. What does the proprietary ratio indicate?
The proprietary ratio shows the proportion of total assets financed by owners’ funds. A higher ratio means more assets are financed by equity, indicating strong financial health and lower liquidity risk. A lower ratio suggests higher dependence on external debt, increasing the risk for creditors and investors.
4. What is considered an ideal proprietary ratio?
An ideal proprietary ratio is generally 0.5:1 (or 50%) or more. This means that at least half of the company’s total assets are financed by shareholders’ funds. Such a ratio indicates strong financial stability and less reliance on debt; however, the ideal may vary by industry.
5. How do you calculate proprietary ratio from the balance sheet?
To calculate the proprietary ratio from the balance sheet:
• Identify Equity Share Capital and Reserves & Surplus.
• Subtract any fictitious assets (like preliminary expenses) from these.
• Add up all assets (fixed and current) to get Total Assets.
• Apply the formula: Proprietary Ratio = Proprietors’ Funds / Total Assets.
6. What components are included in proprietors’ funds?
Proprietors’ funds include:
• Equity Share Capital
• Preference Share Capital (if considered owners’ fund as per question)
• Reserves and Surplus (accumulated profits)
• Less: Fictitious assets like preliminary expenses or accumulated losses.
7. How does proprietary ratio differ from debt-equity ratio?
The proprietary ratio measures the share of assets financed by owners’ funds, while the debt-equity ratio measures the relationship between outside liabilities and owners’ funds.
• Proprietary Ratio = Proprietors’ Funds / Total Assets.
• Debt-Equity Ratio = Outsiders’ Funds / Proprietors’ Funds.
A high proprietary ratio means lower risk, while a high debt-equity ratio indicates greater financial risk.
8. Why is proprietary ratio important for exam preparation?
The proprietary ratio is important because it helps students:
• Analyze solvency and capital structure in board exam numericals.
• Interpret balance sheets as required by CBSE/ISC syllabus.
• Avoid common calculation errors by understanding formula components.
• Score marks in case studies, conceptual, and calculation-based questions.
9. What happens if a company has a very low proprietary ratio?
A very low proprietary ratio means the company relies heavily on external debt to finance its assets. This increases financial risk, makes it harder to get loans, and may signal potential liquidity issues or higher risk of insolvency.
10. Can proprietary ratio be negative?
Yes, the proprietary ratio can be negative if the company’s total liabilities exceed total assets, resulting in negative owners’ funds. A negative proprietary ratio indicates serious financial distress and possible insolvency.
11. Are fictitious assets included in the calculation of proprietary ratio?
No, fictitious assets (e.g., preliminary expenses, debit balance of Profit & Loss Account) are deducted from proprietors’ funds when calculating the proprietary ratio. This ensures the ratio reflects only genuine capital contributed by owners.
12. Is proprietary ratio relevant for all types of companies?
The proprietary ratio is relevant for most types of companies, especially when assessing long-term solvency and capital structure. However, its interpretation may vary for capital-intensive industries and financial institutions, so it should always be used alongside other ratios for comprehensive analysis.
