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Financial Management and Business Data Analytics · Financial Ratio Analysis

Solvency and Leverage Ratios: Debt-Equity, ICR, DSCR, Gearing

Updated 10 October 2026 · Fact-checked

Solvency ratios test whether a business can meet its long-term obligations. The main ones are debt-equity ratio (debt ÷ equity), interest coverage ratio (EBIT ÷ interest), debt service coverage ratio (cash available for debt service ÷ interest plus principal) and capital gearing (fixed-return capital ÷ equity capital). Define each term first, then substitute and interpret.

Understand Solvency and Leverage Ratios

Solvency means the ability of a firm to pay its long-term liabilities: interest on borrowings and repayment of principal when due. Liquidity ratios look at the next twelve months. Solvency ratios look at the long-term strength of the capital structure and the earnings that support it.

There are two groups. Structural ratios look at the balance sheet and show how much of the business is financed by borrowed money versus owners' money: the debt-equity ratio and capital gearing. Coverage ratios look at the profit and loss account or cash flows and show whether earnings can pay the fixed charges: interest coverage and debt service coverage.

More debt means more leverage. Debt can raise returns to shareholders because interest is a fixed cost, but it also raises risk. Lenders must be paid whether or not the firm earns a profit. So a high debt-equity ratio or a low coverage ratio signals higher risk. A very low debt ratio may mean the firm is not using cheap borrowing, though it is safer.

There is no single correct value. Acceptable levels depend on the industry, the stability of earnings and the asset base. Capital-intensive firms with steady cash flows (power, infrastructure) can carry more debt than firms with volatile earnings. In answers, always compare with an industry norm, a past year or a competitor, and state what the number means.

The main trap is definitions. The terms debt, equity, capital employed and fixed-return funds differ between textbooks. State the definition you use at the start of your answer, and apply it consistently. Where the question gives a definition, use it.

Key rules to remember

Debt-equity ratio (long-term debt basis)
Debt-equity ratio = Long-term debt ÷ Shareholders' equity
Long-term debt means borrowings repayable after more than a year (debentures, term loans). Equity = equity share capital + preference share capital (if treated as equity) + reserves and surplus. Use the definition given in the question.
Debt-equity ratio (total outside liabilities basis)
Total outside liabilities ÷ Shareholders' equity
A wider version that includes current liabilities. Use only when the question asks for it or defines it so.
Interest coverage ratio (ICR)
ICR = EBIT ÷ Interest on long-term debt (fixed interest charges)
Answer in times. EBIT is profit before interest and tax. Higher means safer.
Debt service coverage ratio (DSCR)
DSCR = Earnings available for debt service ÷ (Interest + Repayment of principal instalment)
Earnings available for debt service is commonly PAT + depreciation + other non-cash charges + interest on term loans. Say this in your answer. Preference dividend is sometimes added to the denominator if the question says so.
Capital gearing ratio
Capital gearing = Fixed-return (fixed-cost) capital ÷ Equity shareholders' funds
Fixed-return capital = preference share capital + debentures + long-term loans. Equity funds = equity share capital + reserves and surplus. Gearing above 1 is usually treated as highly geared (fixed-return capital exceeds equity), but compare with industry norms.
Proprietary ratio (supporting)
Proprietary ratio = Shareholders' funds ÷ Total assets
Shows the share of assets funded by owners. It moves opposite to the debt-equity ratio.

How to solve Solvency and Leverage Ratios questions

Use this sequence for any solvency question, whether the data comes as a balance sheet, an income statement, or direct figures.

  1. 1Read which ratios are asked and note any definition the question gives. Use that definition even if it differs from your textbook.
  2. 2Pull out the balance sheet items: long-term debt, preference capital, equity share capital, reserves and surplus. Leave current liabilities out unless the ratio needs them.
  3. 3Pull out the earnings items: EBIT, interest, depreciation, PAT, and any loan instalment due in the year.
  4. 4Write the formula, then substitute the numbers on a separate line. Show both numerator and denominator, because step marks are given for them.
  5. 5Calculate and round sensibly (two decimals). Give ratios as 'x : 1' or 'times' as appropriate.
  6. 6Interpret in one or two sentences: is the firm highly geared or comfortable, and what does that mean for lenders and shareholders?
  7. 7If asked, compare with a norm, a previous year or another firm, and give a short recommendation.

Quickest way: Two-column grouping for solvency questions

When to use it: Use when the question gives a full balance sheet and asks for several ratios in one go.

  1. Draw two columns: Fixed-return funds and Equity funds.
  2. Place debentures, term loans and preference capital in the first column. Place equity share capital and all reserves in the second.
  3. Total each column once. These two totals give both capital gearing and (with debt only) the debt-equity ratio.
  4. For coverage ratios, write EBIT and interest first, then divide. For DSCR, add back non-cash charges to PAT before dividing.
  5. Write one line of interpretation per ratio before moving on.

Common mistakes in Solvency and Leverage Ratios

  • Putting current liabilities into the debt of the debt-equity ratio when the question expects long-term debt only.

    Students treat every liability as debt.

    Fix: Use long-term borrowings unless the question states total outside liabilities. Write your definition in the answer.

  • Using PAT instead of EBIT in the interest coverage ratio.

    PAT is the profit figure that is easiest to spot.

    Fix: PAT is after interest, so interest would be deducted twice. Use EBIT, or PBT plus interest.

  • Leaving out the principal repayment in DSCR, so it becomes the same as ICR.

    Students mix up the two coverage ratios.

    Fix: ICR covers interest only. DSCR covers interest plus the principal instalment due in the year.

  • Forgetting to add back depreciation and interest to PAT for earnings available for debt service.

    Students use PAT directly.

    Fix: Depreciation is non-cash, and interest is added back because it is part of the debt service in the denominator.

  • Putting preference capital in the equity column when calculating capital gearing.

    Preference shares are shown under share capital in the balance sheet.

    Fix: For gearing, preference capital carries a fixed return, so place it with fixed-return capital.

  • Giving the number without any interpretation.

    Students assume the calculation is the answer.

    Fix: Add a sentence stating whether the ratio is high or low, and what it means for risk, lenders and shareholders.

Worked examples

Example 1

The following information is taken from the books of Sagar Foods Ltd. as on 31 March: Equity share capital ₹40,00,000; Reserves and surplus ₹20,00,000; 10% preference share capital ₹10,00,000; 12% debentures ₹30,00,000; Term loan ₹20,00,000. Calculate (a) debt-equity ratio (long-term debt ÷ equity, treating preference capital as equity), and (b) capital gearing ratio. Comment.

Show the solution
  1. Long-term debt = debentures ₹30,00,000 + term loan ₹20,00,000 = ₹50,00,000.
  2. (a) Equity including preference = 40,00,000 + 20,00,000 + 10,00,000 = ₹70,00,000.
  3. Debt-equity ratio = 50,00,000 ÷ 70,00,000 = 0.71 : 1.
  4. (b) Fixed-return capital = preference 10,00,000 + debentures 30,00,000 + term loan 20,00,000 = ₹60,00,000.
  5. Equity shareholders' funds = 40,00,000 + 20,00,000 = ₹60,00,000.
  6. Capital gearing = 60,00,000 ÷ 60,00,000 = 1.00.
  7. Comment: debt is below equity on the first basis, but including preference capital, fixed-return funds equal equity funds. A gearing of 1.00 sits at the borderline between low and high gearing, so the company must keep earning enough to cover its fixed charges.

Answer: Debt-equity ratio = 0.71 : 1; Capital gearing = 1.00 (borderline between low and high gearing; fixed-return funds equal equity funds).

Example 2

Meera Textiles Ltd. has the following data for the year: EBIT ₹12,00,000; interest on term loan ₹2,00,000; profit after tax ₹6,00,000; depreciation ₹1,50,000; term loan principal instalment due in the year ₹3,00,000. Calculate the interest coverage ratio and the debt service coverage ratio. Comment.

Show the solution
  1. ICR = EBIT ÷ interest = 12,00,000 ÷ 2,00,000 = 6 times.
  2. Earnings available for debt service = PAT 6,00,000 + depreciation 1,50,000 + interest 2,00,000 = ₹9,50,000.
  3. Debt service = interest 2,00,000 + principal 3,00,000 = ₹5,00,000.
  4. DSCR = 9,50,000 ÷ 5,00,000 = 1.90 times.
  5. Comment: EBIT covers interest six times, so interest is very safe. DSCR of 1.90 is lower because principal repayment is included, but cash earnings still cover total debt service almost twice.

Answer: ICR = 6 times; DSCR = 1.90 times. The firm can comfortably service both interest and principal.

Exam tips

  • Start every answer with the formula and the definition you are using. Examiners give marks for the method even if the final value differs because of a definition.
  • In MCQs, check whether the question asks ICR or DSCR. Options often include the other ratio's value as a distractor. There is no negative marking, so always attempt.
  • For DSCR, scan the data for the principal instalment and depreciation. Missing either gives a wrong answer.
  • Always add an interpretation line. Many 14-mark ratio questions reserve marks for comments and for comparing with a norm or another year.
  • Keep a two-column fixed-return versus equity layout on your rough sheet. It makes gearing and debt-equity quick and error-free.

Practice questions from Financial Ratio Analysis

Solvency 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.

Solvency and Leverage Ratios: frequently asked questions

What is the difference between interest coverage ratio and DSCR?

The interest coverage ratio divides EBIT by interest only, so it shows how safely interest is covered. DSCR divides cash earnings available for debt service by interest plus principal repayment. DSCR is the stricter test because it includes the loan instalment.

What is a good debt-equity ratio?

There is no single figure that suits every firm. It depends on the industry and on how stable earnings are. A lower ratio means lower risk to lenders, while a higher ratio means more leverage and more risk. Judge it against industry norms and the firm's own past.

How do I calculate the capital gearing ratio?

Divide fixed-return capital by equity shareholders' funds. Fixed-return capital includes preference shares, debentures and long-term loans. Equity funds include equity share capital and reserves. A ratio above 1 is usually treated as highly geared, since fixed-return capital exceeds equity, but compare it with industry norms.

Do I use EBIT or PAT for interest coverage?

Use EBIT, which is profit before interest and tax. PAT is already after interest, so using it would deduct interest twice and give a wrong answer.