Solvency and Capital Structure Ratios

Gearing = 250,000 ÷ (750,000 + 250,000) × 100 = 250,000 ÷ 1,000,000 × 100 = 25%. As this is well below 50%, the company is low geared (mostly equity financed).

Interest cover = 360,000 ÷ 45,000 = 8 times.

Company Q carries more financial risk. It is highly geared (68%), so a large part of its finance is debt with fixed interest, and its interest cover is only 1.6 times, meaning its profits barely cover the interest. Company P is low geared (30%) with interest cover of 9 times, so it can comfortably service its debt. Q is therefore far more vulnerable if profits fall.

Debt carries a fixed interest cost that does not change with profit, and raising debt does not create new shares. If the company earns a return on the borrowed funds that exceeds the interest cost, the surplus belongs to the existing ordinary shareholders, who do not have to share it with new shareholders. So in profitable years, debt can increase the return on equity — this is financial leverage.

The risk is that this works in reverse in poor years: interest must still be paid in full, so if profits fall, there is less left for shareholders, and if profits fall below the interest cost the company makes a loss and may struggle to pay the interest. Higher gearing therefore magnifies both gains and losses to shareholders.

Increasing gearing to 70% means relying much more heavily on debt, which brings larger fixed interest payments and the obligation to repay the borrowing. The main risks are: if profits fall — for example in a downturn — there may be too little to cover the higher interest, reducing interest cover and risking default or insolvency; the company has less flexibility because of the fixed commitments; lenders may be reluctant to provide further finance and may charge higher interest for the increased risk; and shareholders face greater volatility in their returns. The decision depends on whether the company's profits are stable and strong enough to comfortably service the extra debt (i.e. maintain adequate interest cover); if they are volatile, the higher gearing is risky.

Debenture (debt) issue. Advantages: interest is usually cheaper than the return shareholders require and is tax-deductible; there is no dilution of control or earnings for existing shareholders; and, as the company is currently low geared with stable profits, it can comfortably take on more debt while keeping interest cover healthy. In profitable years the debt would boost the return on equity (leverage). Disadvantages: it raises gearing and financial risk, the interest is a fixed commitment, and the debentures must be repaid.

Share issue (equity). Advantages: no fixed interest or repayment obligation, keeping risk low; suitable if future profits were uncertain. Disadvantages: it dilutes existing shareholders' control and earnings per share, and equity is generally the more expensive form of finance; it also wastes the company's low-gearing capacity to use cheap debt.

Recommendation: because the company is low geared with stable, strong earnings, it can safely raise the debentures — gaining cheaper finance, retaining control, and boosting shareholder returns — provided the resulting interest cover remains comfortable. A share issue would be more appropriate only if profits were volatile or gearing were already high.

Although both companies are highly geared (60%) and therefore both rely heavily on debt with fixed interest, their risk is very different once interest cover and profit stability are considered.

Company A has interest cover of 7 times and stable profits, so its earnings comfortably cover the interest with a large margin, and that margin is reliable because profits do not fluctuate much. Even though it is highly geared, A can service its debt safely, so its financial risk is relatively low.

Company B has interest cover of only 1.4 times and volatile profits: its earnings barely cover the interest, and because profits fluctuate, a downturn could easily leave it unable to pay the interest, risking default or insolvency. B is therefore in a much riskier position.

This shows that the gearing ratio alone is not enough — interest cover and the stability of profits are essential to assessing how dangerous a given level of gearing really is.

1. Issue new ordinary shares (raise equity) and use the proceeds to repay some of its debt — this increases equity and reduces debt, lowering the gearing ratio. 2. Retain a greater share of profits (by paying lower dividends) to build up reserves and/or repay loans/debentures as they fall due. Both approaches increase equity relative to debt, which reduces gearing.

Even though gearing is unchanged (50%), the fall in interest cover from 6 to 2 times shows the company's profits now provide a much smaller margin over its interest charge. This means either profits have fallen or interest costs have risen (or both). The company is now more financially vulnerable: a further fall in profit could leave it unable to cover its interest, increasing the risk of default. So its financial risk has increased significantly despite the stable gearing — illustrating why interest cover must be monitored alongside gearing.

Gearing measures the proportion of a company's long-term capital that is provided by debt (such as loans and debentures) rather than equity, usually calculated as non-current liabilities ÷ (equity + non-current liabilities) × 100. A high gearing ratio indicates that the company relies heavily on borrowing, so it carries a large amount of fixed-interest debt and therefore greater financial risk (interest must be paid regardless of profit).