9.3 Solvency, Gearing & Debt Risk Ratios

Assessing Long-Term Solvency and Financial Risk

While liquidity focuses on the short term, solvency evaluates the long-term financial stability of a business. A primary concern for any long-term investor or lender is the capital structure of the business—specifically, the balance between debt and equity financing.

Financial Gearing (Leverage)

Gearing (also known as leverage) measures the proportion of a company's total long-term funding that is provided by debt.

Debt includes any interest-bearing liabilities, such as bank loans, debentures, and bonds. Equity represents the capital belonging to the shareholders, including share capital, share premium, and retained earnings.

The distinction between debt and equity is critical because of the associated obligations:

• Debt carries a legal obligation to pay fixed interest payments, regardless of whether the company makes a profit. Furthermore, the principal amount must usually be repaid at a specific future date.
• Equity does not carry a mandatory payment. Dividends are paid at the discretion of the directors, and equity capital does not generally have a repayment date.

Consequently, higher levels of debt introduce higher financial risk. If a highly geared company experiences a downturn in trading, it must still meet its fixed interest obligations. If it fails to do so, debt holders can force the company into liquidation.

Calculating Gearing

Under the ACCA FA syllabus, there are two accepted methods for calculating the gearing ratio. Unless a specific method is requested, either can be used, provided it is used consistently for comparison.

Method A: Debt to Equity Ratio Gearing = (Interest-Bearing Debt / Total Equity) × 100%

Method B: Debt to Total Capital Ratio Gearing = (Interest-Bearing Debt / (Total Equity + Interest-Bearing Debt)) × 100%

Note: In examinations, ensure you only include long-term interest-bearing debt (non-current liabilities), unless short-term borrowings like overdrafts form a permanent part of the capital structure.

Interpretation of Gearing:

• A company is generally considered "highly geared" if its gearing ratio is greater than 50% (using Method B) or greater than 100% (using Method A).
• A highly geared company is riskier for equity investors and future lenders. Lenders will charge higher interest rates to compensate for the elevated risk of default.
• Conversely, a low-geared company is considered financially conservative and stable, offering greater security to lenders and less risk of bankruptcy.

The Benefit of Debt (Financial Leverage)

If debt introduces so much risk, why do companies use it? The answer is financial leverage. Debt is generally a cheaper source of finance than equity (partly because interest payments are tax-deductible).

If a company borrows money at an interest rate of 6% and invests that capital into projects that generate a Return on Capital Employed (ROCE) of 15%, the surplus 9% accrues directly to the equity shareholders. Therefore, a judicious amount of debt can actually enhance the returns for shareholders, provided the economic environment remains favorable.

Interest Cover Ratio

While the gearing ratio looks at the statement of financial position to assess risk, the Interest Cover Ratio looks at the statement of profit or loss to assess the company's ability to service its debt.

Formula: Interest Cover = Operating Profit / Finance Costs (Interest Expense)

Interpretation: This ratio measures how many times the operating profit (PBIT) covers the mandatory interest payments.

• A higher ratio indicates a comfortable margin of safety. If profits fall, the company can still pay its interest.
• A general benchmark suggests a safe interest cover is a minimum of 3 times.
• If the ratio falls to 1 time or below, the company is generating only enough profit to pay its interest, leaving nothing for taxes, dividends, or reinvestment. This is highly precarious.

Worked Numerical Example

Consider Gamma plc with the following financial data:

• Operating Profit: $500,000
• Finance Costs (Interest): $100,000
• Total Equity: $1,200,000
• Long-term Bank Loan: $800,000

Calculations:

• Gearing (Method A): ($800,000 / $1,200,000) × 100% = 66.7%
• Gearing (Method B): ($800,000 / ($1,200,000 + $800,000)) × 100% = 40.0%
• Interest Cover: $500,000 / $100,000 = 5.0 times

Commentary: Gamma plc has a moderate level of gearing (40% of total capital is debt). The company appears financially stable in its ability to service this debt, as its operating profit covers its interest obligations a healthy 5 times. Even if operating profits were to halve to $250,000, the interest cover would still be 2.5 times, meaning default is unlikely in the short term.