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Business Finance · Interpreting company accounting information

Gearing and Solvency Ratios: Calculating and Interpreting Financial Risk

Updated 11 October 2026 · Fact-checked

Gearing ratios show how much of a company's capital comes from debt. Interest cover shows how easily profit pays the interest. Calculate each ratio from the accounts, compare it with past years or peers, then explain what it means for financial risk and long-term solvency. State your definition first.

Understand Gearing and Solvency Ratios

A company funds itself with equity (shareholders' money) and debt (loans, bonds, debentures). Debt carries a fixed interest cost that must be paid whether or not the company makes a profit. Equity dividends can be cut. This is why debt adds risk.

Gearing (also called leverage) measures how heavily the company relies on debt. Higher gearing means more fixed interest commitments. In good years, shareholders gain because profit above the interest cost belongs to them. In bad years, profits can fall sharply and the company may fail to pay lenders.

There are two types of measure. Capital structure ratios such as gearing and debt-to-equity look at the balance sheet. Coverage ratios such as interest cover look at the profit and loss account. Together they describe financial risk and long-term solvency, meaning the ability to meet debts over many years.

Definitions vary. Some texts use total debt, some use net debt (debt less cash), and some include preference shares or lease liabilities as debt. The exam usually expects you to state your definition and use it consistently. Always follow any definition given in the question.

A ratio alone proves little. Compare it with the company's earlier years, with similar firms in the same industry, and with the stability of its profits. A utility with steady cash flows can carry more debt than a firm with volatile profits.

Key rules to remember

Gearing ratio (debt to capital employed)
Gearing = Debt ÷ (Debt + Equity) × 100%
Debt is usually long-term borrowings, sometimes with preference shares. Equity is share capital plus reserves. State your definition.
Gearing ratio (debt to equity version)
Gearing = Debt ÷ Equity × 100%
This is the same as the debt-to-equity ratio. Some books use the term gearing for this form.
Debt-to-equity ratio
Debt-to-equity = Debt ÷ Equity
Can be shown as a percentage or as a ratio such as 0.5 : 1.
Interest cover
Interest cover = Profit before interest and tax (PBIT) ÷ Interest expense
Shown in times. Use finance costs from the profit and loss account. Higher means safer.
Converting between the two gearing forms
Debt ÷ (Debt + Equity) = (D/E) ÷ (1 + D/E)
For example, D/E of 0.5 gives 0.5 ÷ 1.5 = 33.3%.

How to solve Gearing and Solvency Ratios questions

Use this method for any question on gearing and solvency ratios.

  1. 1Read the question and note which definition of debt and equity is required. If none is given, choose one and state it.
  2. 2Pick out the figures: long-term debt, equity (share capital plus reserves), PBIT and interest expense.
  3. 3Write the formula before you substitute numbers.
  4. 4Calculate each ratio for each year or company, and show the working.
  5. 5Compare with the earlier year, the other company or the industry norm. Note the direction of change.
  6. 6Explain the meaning: higher gearing means higher financial risk, and low interest cover means thin protection for lenders.
  7. 7Add context such as profit stability, asset backing, cash flow and interest rates, and note any limits of the ratio.
  8. 8Conclude with a clear view on risk and solvency.

Quickest way: Four-line gearing check

When to use it: Use this in multiple-choice questions or when time is short on a written question.

  1. Identify what the question calls debt. Check if preference shares or cash are included.
  2. Compute D ÷ (D + E) or D ÷ E, whichever is asked. Do not mix them up.
  3. Compute PBIT ÷ interest for cover.
  4. Say in one line what the result means: higher gearing means more risk, lower cover means less safety margin.

Common mistakes in Gearing and Solvency Ratios

  • Mixing up gearing as debt ÷ (debt + equity) with debt ÷ equity.

    Textbooks use the word gearing for both forms.

    Fix: Read the definition in the question. If none is given, state which form you use. Check that D ÷ E is always larger than D ÷ (D + E).

  • Using profit after interest or after tax in interest cover.

    Students take the last profit line on the statement.

    Fix: Use profit before interest and tax in the numerator. Interest must not already be deducted.

  • Including current liabilities such as trade payables as debt.

    All liabilities are seen as borrowings.

    Fix: Include interest-bearing borrowings only, unless the question says otherwise. State if short-term loans are included.

  • Saying high gearing is always bad.

    Students memorise that debt means risk.

    Fix: Say it raises financial risk and can raise returns to shareholders in good years. Discuss profit stability and the cost of debt.

  • Using book values without comment.

    The accounts only provide book values.

    Fix: Note that book equity may differ from market value, so market-based gearing can give another picture.

  • Giving numbers without interpretation.

    Students stop after the calculation.

    Fix: Write at least a sentence on what the ratio means for risk and for solvency and compare it with a benchmark.

Worked examples

Example 1

A company has long-term debt of ₹40,00,000, share capital of ₹30,00,000 and reserves of ₹50,00,000. PBIT is ₹24,00,000 and interest expense is ₹4,00,000. Calculate the gearing ratio (debt ÷ (debt + equity)), the debt-to-equity ratio and the interest cover.

Show the solution
  1. Equity = 30,00,000 + 50,00,000 = ₹80,00,000.
  2. Debt + equity = 40,00,000 + 80,00,000 = ₹1,20,00,000.
  3. Gearing = 40,00,000 ÷ 1,20,00,000 = 33.3%.
  4. Debt-to-equity = 40,00,000 ÷ 80,00,000 = 0.5, or 50%.
  5. Interest cover = 24,00,000 ÷ 4,00,000 = 6 times.
  6. Check the link: 0.5 ÷ 1.5 = 33.3%, which agrees.

Answer: Gearing is 33.3%, debt-to-equity is 0.5 (50%) and interest cover is 6 times. Profit covers interest six times, so the company looks comfortably able to service its debt.

Example 2

Company X has debt of ₹60,00,000 and equity of ₹40,00,000 in Year 1. PBIT is ₹15,00,000 and interest is ₹6,00,000. In Year 2 it borrows more, so debt is ₹80,00,000 with equity unchanged at ₹40,00,000. Interest rises to ₹8,00,000 while PBIT falls to ₹12,00,000. Compare gearing (debt ÷ (debt + equity)) and interest cover and comment on financial risk.

Show the solution
  1. Year 1 gearing = 60 ÷ (60 + 40) = 60%.
  2. Year 1 interest cover = 15,00,000 ÷ 6,00,000 = 2.5 times.
  3. Year 2 gearing = 80 ÷ (80 + 40) = 80 ÷ 120 = 66.7%.
  4. Year 2 interest cover = 12,00,000 ÷ 8,00,000 = 1.5 times.
  5. Gearing rose and cover fell, so both signals point to higher risk.
  6. In Year 2 a further fall in PBIT of one third, from ₹12,00,000 to ₹8,00,000, would leave no profit after interest.

Answer: Gearing rose from 60% to 66.7% and interest cover fell from 2.5 to 1.5 times. Financial risk has increased sharply. The company has a thin safety margin and could struggle to pay interest if profits fall further.

Exam tips

  • Write the definition of debt and equity you are using before calculating. Examiners award marks for a clear and consistent definition.
  • Show the formula, the substitution and the result. Marks are given for method even if an arithmetic slip occurs.
  • In comparison questions, comment on both the direction and the cause of change, and on the business context.
  • Link ratios to risk and solvency in words. A bare number scores poorly in written questions.
  • In multiple-choice questions, check whether the options use D ÷ E or D ÷ (D + E) before you calculate.

Practice questions from Interpreting company accounting information

Gearing and Solvency Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Gearing and Solvency Ratios: frequently asked questions

What is the difference between the gearing ratio and the debt-to-equity ratio?

Both measure reliance on debt. Debt-to-equity divides debt by equity only. Gearing is often debt divided by total capital (debt plus equity), though some books use the term for debt-to-equity. Always state the definition you use.

How do you calculate interest cover?

Divide profit before interest and tax by interest expense. The answer is in times. A result of 4 means profit is four times the interest bill, so there is a good safety margin.

What is a good gearing ratio?

There is no single figure that is right for all companies. What is acceptable depends on the industry, how stable the profits are and the cost of borrowing. Compare with similar firms and with the company's own history.

Why does high gearing increase financial risk?

Interest on debt is a fixed cost that must be paid even in poor years. If profits fall, shareholders' returns fall by more than profits do. If the company cannot pay, lenders may take action and the company could fail.