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 stock, preference shares, and bank loans, etc. Formula:

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

Where the ratio intends to measure the proportion of equity finance employed by the company, it is referred to as the leverage ratio. Formula:

$Leverage Ratio = \frac{Equity capital}{Equity capital + Long-term debts} \times 100$

Note: There are different forms of leverage or capital 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: Generally, it is expected that an entity’s financial structure should be 50% debts and 50% equity. Thus, where the gearing ratio is greater than 50%, the firm is said to be highly geared. 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:

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

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:

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

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.

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	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
Accounts 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% Debenture		200,000.00
Current Liabilities:
Account 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 liquidity ratios for Sokoto Company Limited for the year ended 31 December 2024:

Capital gearing ratio
Debt-to-equity ratio
Interest cover
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.

What is the gearing ratio?

(spoiler)

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

All the figures for this ratio are from the statement of financial position.

$Capital gearing Ratio = \frac{$200 , 000}{$439 , 508 + $200 , 000} \times 100 = 31.27%$

A gearing level below the industry benchmark suggests that the company is financing a greater proportion of its long-term capital through equity rather than debt. This indicates a moderate financial risk profile and suggests that the company is not overly dependent on long-term borrowings. For investors and lenders, this signals relative stability and lower risk of financial distress in the long term.

What is the debt-to-equity ratio?

(spoiler)

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

All the figures for this ratio are from the statement of financial position.

$Debt to Equity Ratio = \frac{$200 , 000}{$439 , 508} = 0.45$

A lower debt-to-equity ratio reveals that Sokoto employs a more conservative financing strategy, relying more heavily on equity compared to borrowings. This suggests less exposure to credit risk and potential cash flow pressures.

What is the interest cover?

(spoiler)

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

All the figures for this ratio are from the statement of profit or loss.

$Interest Cover = \frac{$128 , 708}{$16 , 000} = 8.04 times$

With an interest cover of 8.04 times, the company demonstrates a strong ability to service its interest obligations. Although marginally below the industry benchmark, the company’s earnings are still more than sufficient to meet interest payments comfortably. This reflects adequate solvency and manageable financial risk.

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	0.45	0.50	-0.05	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: Sokoto Company Limited exhibits a prudent and conservative financial structure with lower leverage than industry peers. The company’s gearing ratios indicate reduced financial risk and greater resilience during economic challenges. However, the marginally lower interest cover suggests that while debt servicing is comfortable, there is less buffer compared to competitors. The company could potentially optimize its capital structure by taking on moderate additional debt to enhance returns on equity, while maintaining its strong risk profile. Overall, the company demonstrates sound financial management with low default risk.

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.

Gearing ratios assess whether a company’s long-term debt levels are excessive and within manageable control limits.
Capital gearing ratio = (Long-term Debts ÷ Capital Employed) × 100. Measures proportion of debt financing employed.
Ideal financing structure is 50% debt and 50% equity. Above 50% indicates high gearing with increased risk.
High gearing increases interest payment obligations but provides tax benefits through deductible interest expenses on borrowings.
Debt to equity ratio = Long-term Debts ÷ Equity. Lower ratios indicate conservative financing and reduced financial risk.
Interest cover = PBIT ÷ Interest Charges. Measures how many times profit exceeds interest expense obligations. Higher interest cover is better, indicating comfortable debt servicing ability. Low ratios signal potential financial distress.

Next | Wrapping up

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 stock, preference shares, and bank loans, etc. Formula:

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

Where the ratio intends to measure the proportion of equity finance employed by the company, it is referred to as the leverage ratio. Formula:

$Leverage Ratio = \frac{Equity capital}{Equity capital + Long-term debts} \times 100$

Note: There are different forms of leverage or capital 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: Generally, it is expected that an entity’s financial structure should be 50% debts and 50% equity. Thus, where the gearing ratio is greater than 50%, the firm is said to be highly geared. 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:

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

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:

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

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.

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	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
Accounts 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% Debenture		200,000.00
Current Liabilities:
Account 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 liquidity ratios for Sokoto Company Limited for the year ended 31 December 2024:

Capital gearing ratio
Debt-to-equity ratio
Interest cover
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.

What is the gearing ratio?

(spoiler)

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

All the figures for this ratio are from the statement of financial position.

$Capital gearing Ratio = \frac{$200 , 000}{$439 , 508 + $200 , 000} \times 100 = 31.27%$

A gearing level below the industry benchmark suggests that the company is financing a greater proportion of its long-term capital through equity rather than debt. This indicates a moderate financial risk profile and suggests that the company is not overly dependent on long-term borrowings. For investors and lenders, this signals relative stability and lower risk of financial distress in the long term.

What is the debt-to-equity ratio?

(spoiler)

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

All the figures for this ratio are from the statement of financial position.

$Debt to Equity Ratio = \frac{$200 , 000}{$439 , 508} = 0.45$

A lower debt-to-equity ratio reveals that Sokoto employs a more conservative financing strategy, relying more heavily on equity compared to borrowings. This suggests less exposure to credit risk and potential cash flow pressures.

What is the interest cover?

(spoiler)

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

All the figures for this ratio are from the statement of profit or loss.

$Interest Cover = \frac{$128 , 708}{$16 , 000} = 8.04 times$

With an interest cover of 8.04 times, the company demonstrates a strong ability to service its interest obligations. Although marginally below the industry benchmark, the company’s earnings are still more than sufficient to meet interest payments comfortably. This reflects adequate solvency and manageable financial risk.

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	0.45	0.50	-0.05	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

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.

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9. Interpretation of financial statements

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Gearing ratios

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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 stock, preference shares, and bank loans, etc. Formula:

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

Where the ratio intends to measure the proportion of equity finance employed by the company, it is referred to as the leverage ratio. Formula:

$Leverage Ratio = \frac{Equity capital}{Equity capital + Long-term debts} \times 100$

Note: There are different forms of leverage or capital 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: Generally, it is expected that an entity’s financial structure should be 50% debts and 50% equity. Thus, where the gearing ratio is greater than 50%, the firm is said to be highly geared. 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:

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

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:

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

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.

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	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
Accounts 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% Debenture		200,000.00
Current Liabilities:
Account 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 liquidity ratios for Sokoto Company Limited for the year ended 31 December 2024:

Capital gearing ratio
Debt-to-equity ratio
Interest cover
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.

What is the gearing ratio?

(spoiler)

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

All the figures for this ratio are from the statement of financial position.

$Capital gearing Ratio = \frac{$200 , 000}{$439 , 508 + $200 , 000} \times 100 = 31.27%$

A gearing level below the industry benchmark suggests that the company is financing a greater proportion of its long-term capital through equity rather than debt. This indicates a moderate financial risk profile and suggests that the company is not overly dependent on long-term borrowings. For investors and lenders, this signals relative stability and lower risk of financial distress in the long term.

What is the debt-to-equity ratio?

(spoiler)

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

All the figures for this ratio are from the statement of financial position.

$Debt to Equity Ratio = \frac{$200 , 000}{$439 , 508} = 0.45$

A lower debt-to-equity ratio reveals that Sokoto employs a more conservative financing strategy, relying more heavily on equity compared to borrowings. This suggests less exposure to credit risk and potential cash flow pressures.

What is the interest cover?

(spoiler)

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

All the figures for this ratio are from the statement of profit or loss.

$Interest Cover = \frac{$128 , 708}{$16 , 000} = 8.04 times$

With an interest cover of 8.04 times, the company demonstrates a strong ability to service its interest obligations. Although marginally below the industry benchmark, the company’s earnings are still more than sufficient to meet interest payments comfortably. This reflects adequate solvency and manageable financial risk.

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	0.45	0.50	-0.05	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

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.

Gearing ratios assess whether a company’s long-term debt levels are excessive and within manageable control limits.
Capital gearing ratio = (Long-term Debts ÷ Capital Employed) × 100. Measures proportion of debt financing employed.
Ideal financing structure is 50% debt and 50% equity. Above 50% indicates high gearing with increased risk.
High gearing increases interest payment obligations but provides tax benefits through deductible interest expenses on borrowings.
Debt to equity ratio = Long-term Debts ÷ Equity. Lower ratios indicate conservative financing and reduced financial risk.
Interest cover = PBIT ÷ Interest Charges. Measures how many times profit exceeds interest expense obligations. Higher interest cover is better, indicating comfortable debt servicing ability. Low ratios signal potential financial distress.

Next | Wrapping up

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 stock, preference shares, and bank loans, etc. Formula:

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

Where the ratio intends to measure the proportion of equity finance employed by the company, it is referred to as the leverage ratio. Formula:

$Leverage Ratio = \frac{Equity capital}{Equity capital + Long-term debts} \times 100$

Note: There are different forms of leverage or capital 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: Generally, it is expected that an entity’s financial structure should be 50% debts and 50% equity. Thus, where the gearing ratio is greater than 50%, the firm is said to be highly geared. 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:

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

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:

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

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.

Illustration: Financial statement analysis

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)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	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
Accounts 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% Debenture		200,000.00
Current Liabilities:
Account 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 liquidity ratios for Sokoto Company Limited for the year ended 31 December 2024:

Capital gearing ratio
Debt-to-equity ratio
Interest cover
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.

What is the gearing ratio?

(spoiler)

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

All the figures for this ratio are from the statement of financial position.

$Capital gearing Ratio = \frac{$200 , 000}{$439 , 508 + $200 , 000} \times 100 = 31.27%$

A gearing level below the industry benchmark suggests that the company is financing a greater proportion of its long-term capital through equity rather than debt. This indicates a moderate financial risk profile and suggests that the company is not overly dependent on long-term borrowings. For investors and lenders, this signals relative stability and lower risk of financial distress in the long term.

What is the debt-to-equity ratio?

(spoiler)

$Debt to Equity Ratio = \frac{Long-term debts}{Equity capital}$

All the figures for this ratio are from the statement of financial position.

$Debt to Equity Ratio = \frac{$200 , 000}{$439 , 508} = 0.45$

A lower debt-to-equity ratio reveals that Sokoto employs a more conservative financing strategy, relying more heavily on equity compared to borrowings. This suggests less exposure to credit risk and potential cash flow pressures.

What is the interest cover?

(spoiler)

$Interest Cover = \frac{Profit before Interest and Tax (PBIT)}{Interest Charges (Finance Cost)}$

All the figures for this ratio are from the statement of profit or loss.

$Interest Cover = \frac{$128 , 708}{$16 , 000} = 8.04 times$

With an interest cover of 8.04 times, the company demonstrates a strong ability to service its interest obligations. Although marginally below the industry benchmark, the company’s earnings are still more than sufficient to meet interest payments comfortably. This reflects adequate solvency and manageable financial risk.

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	0.45	0.50	-0.05	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

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.