Gearing ratios

Learning objective

By the end of this module, you should be able to:

• Calculate key accounting ratios related to gearing
• Calculate and interpret the relationship between the elements of the financial statements regarding profitability, liquidity, efficient use of resources, and financial position.
• Draw valid conclusions from the information contained within the financial statements and present these to the appropriate user of the financial statements.

Gearing ratios

Gearing ratios help you assess whether an entity’s long-term debt level is manageable (that is, within control and not excessive). This group of ratios includes:

• Capital gearing ratio
• Debt to equity ratio
• Interest cover

Definitions

Capital gearing ratio

It measures the proportion of debt finance employed by a company. These debts are in the form of debentures, loan notes, redeemable preference shares (irredeemable preference shares are part of equity), and bank loans, etc. Formula:

$$\text{Capital gearing ratio}=\frac{\text{Total long-term debts}}{\text{Equity capital}+\text{Long-term debts}}\times 100$$

Leverage is another name for gearing, so a highly geared company is also described as highly leveraged.

Note: There are different forms of gearing ratios. For example, debt to total asset ratio, asset to equity ratio, etc. The major thing is to identify the description or requirement in the question.

Interpretation: As a rule of thumb, a company with gearing above 50% is often described as highly geared, though acceptable levels vary by industry. This may indicate higher interest payments notwithstanding the tax benefits it might bring. In the case of year-on-year analysis, an increase in the gearing ratio indicates that either borrowings are increasing faster than equity, or equity is falling more quickly than borrowings.

Debt to equity ratio

It measures the proportion of debt finance to equity. Formula:

$$\text{Debt to equity ratio}=\frac{\text{Long-term debts}}{\text{Equity capital}}$$

Interest cover

It measures the number of times profits exceed interest expense. It shows whether enough profits are being earned to meet interest expenses when they become due. It is important to note that this is a ratio based on profitability, not cashflow which would be a better indicator of a company’s ability to pay interest. Formula:

$$\text{Interest cover}=\frac{\text{Operating profit}}{\text{Interest charges (Finance Cost)}}$$

Operating profit here is profit before interest and tax, which IFRS 18 calls profit before financing and income taxes.

Interpretation: The higher the ratio, the better. A lower ratio may indicate severe financial difficulties or that borrowings are too high for the company to support.

IFRS 18 note: IFRS 18 replaces IAS 1 for periods beginning on or after 1 January 2027 and requires the statement of profit or loss to show two new defined subtotals - operating profit and profit before financing and income taxes. Interest cover uses this profit figure, which is the same as PBIT when there’s no separate investing category.

Illustration: Financial statement analysis

Sokoto Company Limited is a manufacturing company that has been operating for several years. The company’s financial controller has prepared the financial statements for the year ended 31 December 2024. As a financial analyst, you have been asked to evaluate the company’s performance for the period.

The following financial statements have been provided for your analysis:

Statement of profit or loss and other comprehensive income

	$
Sales revenue	935,200.00
Cost of sales	(442,300.00)
Gross profit	492,900.00
Distribution cost	(151,000.00)
Administrative expenses	(213,192.00)
Operating profit (profit before financing and income taxes)	128,708.00
Finance expense	(16,000.00)
Profit before income taxes	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other comprehensive income
Gain on revaluation of property	50,000.00
Total comprehensive income	111,108.00

Statement of financial position as at 31 December 2024

	$	$
Non-current asset:
Property, plant and equipment		522,800.00
Current asset:
Inventories	94,200.00
Trade receivables	119,808.00
Prepaid expenses	5,800.00
Cash at bank	45,200.00
Total current assets		265,008.00
Total asset		787,808.00
Equity and liabilities
Equity:
Ordinary share capital (50,000 shares)	200,000.00
Retained earnings	189,508.00
Revaluation surplus	50,000.00
Total equity		439,508.00
Non-current liabilities:
8% loan notes		200,000.00
Current liabilities:
Trade payables	83,300.00
Accrued expenses	16,400.00
Income tax payable	48,600.00
Total current liabilities		148,300.00
Total equity and liabilities		787,808.00

Ratio	Industry average
Capital gearing ratio	35%
Debt to equity ratio	0.50
Interest cover	9.0 times

Required: Calculate the following gearing (financial position) ratios for Sokoto Company Limited for the year ended 31 December 2024:

1. Capital gearing ratio
2. Debt-to-equity ratio
3. Interest cover
4. Compare each of your calculated ratios with the industry average provided above and comment on Sokoto Company Limited’s performance relative to the industry.

Suggested solutions:

Try calculating the ratios and making the comparisons yourself before reviewing the suggested solution below.

1. What is the gearing ratio?

2. What is the debt-to-equity ratio?

3. What is the interest cover?

Summary table of the analysis

Ratio	Sokoto Company Ltd	Industry average	Variance	Performance analysis
Capital gearing ratio	31.27%	35%	-3.73%	Below industry average - lower financial risk
Debt to equity ratio	0.46	0.50	-0.04	Below industry average - more conservative financing
Interest cover	8.04 times	9.0 times	-0.96 times	Below industry average - slightly lower debt servicing capacity

Overall assessment: Gearing is below the industry average, yet interest cover is also below it. This suggests profit before interest is relatively weak for the debt held, rather than that debt is excessive, so improving operating profit should come before taking on more debt.

Note: This question only performed an industry-level comparison. However, you may be given information for the same company for two (2) different years for a similar comparison. All you need is knowing the formulas and being able to interpret the results in terms of whether it is a good or bad performance, and factors that may have contributed to such results, as well as what could be done to improve the results.