Debt and Gearing Ratios

Debt ratios are concerned with how much the company owes in relation to its size and whether it is getting into heavier debt or improving its situation.

(a) When a company is heavily in debt and seems to be getting even more heavily into debt, banks and other would-be lenders are very soon likely to refuse further borrowing and the company might well find itself in trouble.

(b) When a company is earning only a modest profit before interest and tax, and has a heavy debt burden, there will be very little profit left over for shareholders after the interest charges have been paid.


(1) Debt Ratio

Debt ratio is the ratio of a company’s total debts to its total assets.

(a) Assets consist of non-current assets at their balance sheet value, plus current assets.
(b) Debts consist of all payables, whether current or non-current.

(You can ignore long-term provisions and liabilities, such as deferred taxation)

There is no absolute rule on the maximum safe debt ratio, but as a very general guide, you might regard 50% as a safe limit to debt. In addition, if the debt ratio is over 50% and getting worse, the company’s debt position will be worth looking at more carefully.


(2) Capital Gearing

Capital gearing is concerned with the amount of debt in a company’s long-term capital structure. Gearing ratios provide a long-term measure of liquidity.


Gearing Ratio = Prior charge capital (long-term debt)/Prior charge capital + equity (shareholders’ funds)

Prior charge capital is a long-term loans and preferred shares (if any). It does not include loan repayable within one year and bank overdraft, unless overdraft finance is a permanent part of the business’s capital.



(3) Operating Gearing

Operating gearing measures the proportion of fixed costs to total costs. High operating gearing means that a high proportion of cost is fixed. This has implications for business risk in that if turnover alls, there is little automatic relief in the reduction of variable costs.


Operating gearing can be calculated as Contribution / PBIT


(4) Interest Cover

The interest cover ratio shows whether a company is earning enough profits before interest and tax to pay its interest costs comfortably, or whether its interest costs are high in relation to the size of its profits, so that a fall in profit before interest and tax (PBIT) would then have a significant effect on profits available for ordinary shareholders.


Interest Cover = PBIT/ Interest Charges


An interest cover of 2 times or less would below and it should really exceed 3 times before the company’s interest costs can be considered to be within acceptable limits. Note it is usual to exclude preference dividends from interest charges.


(5) Cash Flow Ratios

Cash flow ratio is ratio of a company’s net cash inflow to its total debts.


Net annual cash inflow/ Total debts


(a) Net annual cash inflow is the amount of cash which the company has coming into the business each year from its operations. This will be shown in a company’s statement of cash flows for the year.

(b) Total debts are short-term and long-term payables, together with provisions for liabilities and charges.

Obviously, a company needs to earn enough cash from operations to be able to meet its foreseeable debts and future commitments, and the cash flow ratio, and changes in the cash flow ratio from one year to the next, provides a useful indicator of a company’s cash position.

(source: BPP Learning Media)



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