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Financial Management and Strategic Management · Financial Analysis and Planning - Ratio Analysis

Capital Structure and Leverage Ratios for CA Intermediate FM

Updated 4 October 2026 · Fact-checked

Capital structure ratios show how much of a firm's funding comes from debt and whether it can pay that debt. Debt-equity, debt to total assets and capital gearing measure the mix. Interest coverage and DSCR measure repayment ability. Define each term, apply its formula, then interpret the result.

Understand Capital Structure and Leverage Ratios

A firm funds its assets with owners' money (equity) and borrowed money (debt). Long-term solvency is the firm's ability to pay interest and repay debt over the long run. Capital structure ratios test this from two sides.

The first side is the funding mix. Debt-equity ratio, debt to total assets and capital gearing show how much the firm relies on borrowing. More debt means fixed obligations, more risk for lenders and more risk for shareholders. Debt can also raise returns to equity when the business earns more than the cost of debt.

The second side is the ability to pay. Interest coverage ratio shows how many times operating profit covers interest. Debt service coverage ratio (DSCR) goes further. It checks whether cash earnings cover both interest and instalments of principal due in the year.

No single ratio is correct for every firm. Capital-intensive firms with steady cash flows can carry more debt than firms with volatile sales. So always compare with the industry, the firm's own past years and any loan covenant given in the question.

Definitions differ between books. In exams, use the definition the question gives. If none is given, state the formula you use and apply it consistently.

Key rules to remember

Debt-equity ratio
Debt-equity ratio = Long-term debt ÷ Shareholders' funds
Some treatments use total outside liabilities instead of long-term debt. State your definition. Shareholders' funds = equity share capital + preference share capital (if treated as equity) + reserves and surplus.
Debt to total assets ratio
Debt to total assets = Total debt ÷ Total assets
Shows the share of assets financed by borrowing. Use the same debt definition as in the other ratio. Often shown as a ratio or percentage.
Capital gearing ratio
Capital gearing ratio = (Preference share capital + Debentures + Long-term loans) ÷ (Equity share capital + Reserves and surplus)
Fixed-return capital against equity funds. Here preference capital is treated as fixed-return capital, not as equity. A ratio above 1 means high gearing (fixed-return capital exceeds equity). A ratio below 1 means low gearing (equity dominates).
Interest coverage ratio
Interest coverage ratio = EBIT ÷ Interest on long-term debt
Answer in times. Use the interest figure the question specifies. A higher ratio means a safer cushion.
Debt service coverage ratio (DSCR)
DSCR = Earnings available for debt service ÷ (Interest + Instalment of principal)
Earnings available = net profit after tax + depreciation and other non-cash charges + interest on long-term debt. Use the version the question gives.
Equity multiplier link
Total assets ÷ Shareholders' funds = 1 + (Outside liabilities ÷ Shareholders' funds)
Outside liabilities means all liabilities other than shareholders' funds, so total assets = shareholders' funds + outside liabilities. Useful when only some balance sheet figures are given.

How to solve Capital Structure and Leverage Ratios questions

Use this order for any capital structure ratio question. It keeps your working clean and earns step marks.

  1. 1Read what the question asks: which ratios, and whether it wants interpretation or comparison.
  2. 2Write the formula for each ratio before putting in numbers. Mention the definition of debt you are using.
  3. 3Build the inputs from the data. Compute shareholders' funds, long-term debt, total assets, EBIT or earnings available as needed.
  4. 4Check for traps: current liabilities, preference shares, accumulated losses, and whether interest or principal figures are annual.
  5. 5Substitute and calculate. Show the working line by line and give the answer to two decimals.
  6. 6Interpret in one or two sentences. Say whether the firm is more or less risky and why.
  7. 7If two years or two firms are given, compare them and state a conclusion.

Quickest way: Fast route for MCQs and written answers

When to use it: Use under time pressure, especially for the 30 marks of MCQs, which have no negative marking, so always attempt every one.

  1. Identify the ratio from the wording. 'Times' points to coverage ratios. Fixed-return capital points to gearing.
  2. For MCQs, compute only the numerator and denominator needed. Eliminate options that go the wrong way, such as a coverage ratio below 1 when EBIT clearly exceeds interest.
  3. Check reasonableness: debt to total assets cannot exceed 1 unless liabilities exceed assets.
  4. For written answers, use a fixed layout: formula, working, answer, one-line interpretation.
  5. Add the line 'Higher gearing means higher financial risk' or 'higher coverage means greater safety' as relevant, to secure interpretation marks.

Common mistakes in Capital Structure and Leverage Ratios

  • Including current liabilities in debt when the question asks for long-term debt.

    Students treat every liability on the balance sheet as debt.

    Fix: Read the definition. Use long-term borrowings only unless the question says total outside liabilities.

  • Using net profit instead of EBIT in interest coverage.

    Net profit is the more familiar figure and is easy to spot.

    Fix: Interest coverage uses profit before interest and tax. Add back interest and tax if given profit after tax.

  • Leaving out principal instalments in DSCR.

    Students confuse DSCR with interest coverage.

    Fix: DSCR has interest plus principal repayment in the denominator and adds back non-cash charges in the numerator.

  • Mixing up capital gearing and debt-equity ratio.

    Both compare borrowed funds with equity.

    Fix: Gearing includes preference share capital as fixed-return capital in the numerator. Debt-equity ratio, in its basic form, uses debt alone.

  • Ignoring accumulated losses or miscalculating shareholders' funds.

    Students add reserves without checking for negative balances.

    Fix: Shareholders' funds = share capital + reserves − accumulated losses. Deduct any losses shown.

  • Giving an answer with no interpretation.

    Students stop once the number is calculated.

    Fix: Add a sentence saying what the figure means for solvency and risk, and compare it with the benchmark if one is given.

Worked examples

Example 1

A company has equity share capital ₹10,00,000, reserves and surplus ₹5,00,000, 10% preference share capital ₹3,00,000, 12% debentures ₹4,00,000 and long-term loan ₹3,00,000. Total assets are ₹30,00,000. Calculate (a) debt-equity ratio, (b) debt to total assets ratio and (c) capital gearing ratio. Treat debt as debentures plus long-term loan. For (a), shareholders' funds include preference share capital. For (c), treat preference share capital as fixed-return capital and equity funds as equity share capital plus reserves and surplus.

Show the solution
  1. For (a), shareholders' funds include preference capital: 10,00,000 + 5,00,000 + 3,00,000 = ₹18,00,000.
  2. Debt = 4,00,000 + 3,00,000 = ₹7,00,000.
  3. (a) Debt-equity ratio = 7,00,000 ÷ 18,00,000 = 0.39.
  4. (b) Debt to total assets = 7,00,000 ÷ 30,00,000 = 0.23.
  5. (c) Capital gearing: preference capital is fixed-return capital here. Fixed-return capital = 3,00,000 + 4,00,000 + 3,00,000 = ₹10,00,000. Equity funds = 10,00,000 + 5,00,000 = ₹15,00,000. Ratio = 10,00,000 ÷ 15,00,000 = 0.67.
  6. Interpretation: debt is well below shareholders' funds and finances only 23% of assets. Gearing of 0.67 is below 1, so equity exceeds fixed-return capital and the company is low geared.

Answer: Debt-equity ratio = 0.39; debt to total assets = 0.23; capital gearing ratio = 0.67. Gearing is below 1, so the company is low geared.

Example 2

A firm has EBIT of ₹12,00,000, interest on long-term debt of ₹3,00,000, tax rate 25%, depreciation ₹2,00,000 and a loan instalment of ₹4,00,000 due this year. Calculate the interest coverage ratio and DSCR. Earnings available for debt service = profit after tax + depreciation + interest.

Show the solution
  1. Interest coverage = EBIT ÷ interest = 12,00,000 ÷ 3,00,000 = 4 times.
  2. PBT = EBIT − interest = 12,00,000 − 3,00,000 = ₹9,00,000.
  3. Tax at 25% = ₹2,25,000. PAT = 9,00,000 − 2,25,000 = ₹6,75,000.
  4. Earnings available for debt service = 6,75,000 + 2,00,000 + 3,00,000 = ₹11,75,000.
  5. Debt service = interest + instalment = 3,00,000 + 4,00,000 = ₹7,00,000.
  6. DSCR = 11,75,000 ÷ 7,00,000 = 1.68 times (rounded).
  7. Interpretation: interest is covered 4 times. After allowing for the instalment, cash earnings still cover total debt service about 1.68 times, so the firm can service its debt.

Answer: Interest coverage = 4 times; DSCR = 1.68 times. The firm has a comfortable margin to service its debt.

Exam tips

  • Write the formula and your definition of debt before calculating. If ICAI's expected definition differs, you still earn method marks.
  • Show intermediate figures such as shareholders' funds, PAT and earnings available. Each earns a step mark.
  • In MCQs, check whether the ratio is asked in times, as a percentage or as a plain ratio, and match the option format.
  • Practise ratio-based problems where only a few figures are given and you must derive the rest from the balance sheet identity.
  • Close every written answer with a one-line comment on risk. Examiners look for interpretation.

Practice questions from Financial Analysis and Planning - Ratio Analysis

Capital Structure and Leverage Ratios in other exams

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

Capital Structure and Leverage Ratios: frequently asked questions

What is the difference between interest coverage ratio and DSCR?

Interest coverage compares EBIT with interest alone. DSCR compares cash earnings available with interest plus principal repayment due. DSCR is the stricter test because lenders also need the principal back.

What is a good debt-equity ratio?

There is no fixed ideal for every firm. Stable, asset-heavy businesses can carry more debt than volatile ones. Compare with the industry, past years and any loan covenant, and state your reasoning.

How is capital gearing different from debt-equity ratio?

Capital gearing compares fixed-return capital, which includes preference shares, debentures and long-term loans, with equity funds. The basic debt-equity ratio compares debt with shareholders' funds. Use the definition the question gives.

Is a higher interest coverage ratio always better?

A higher ratio means a larger safety cushion for paying interest. An extremely high ratio can also mean the firm uses little debt and may be missing the benefit of cheaper borrowing. Judge it with the business context.