Last reviewed: July 2026.
Debt and gearing ratios assess how a business is financed and whether operating performance can support interest and repayment obligations. High gearing increases financial risk, but the appropriate level depends on cash stability, assets, industry and financing terms.
Use consistent definitions because “gearing” can mean debt-to-equity or debt-to-total-capital.
Common gearing formulas
| Measure | Formula | Interpretation |
|---|---|---|
| Debt-to-equity | Interest-bearing debt ÷ Equity × 100 | Debt compared with owner financing. |
| Debt-to-capital | Debt ÷ (Debt + Equity) × 100 | Debt share of long-term capital. |
| Interest cover | Operating profit ÷ Finance costs | Ability of operating profit to cover interest. |
| Net debt-to-equity | (Debt − Cash) ÷ Equity × 100 | Debt after available cash, subject to cash restrictions. |
| Debt service coverage | Cash available for debt service ÷ Principal and interest due | Cash capacity to meet total scheduled debt service. |
What counts as debt?
Definitions may include bank loans, debentures, overdrafts, lease liabilities and other interest-bearing obligations. Some analyses include preference shares with debt-like features.
State the definition and use it consistently across periods and companies.
What counts as equity?
Equity usually includes share capital, reserves and retained earnings attributable to owners. Analysts may adjust for non-controlling interests or intangible assets depending on the purpose.
Negative or very small equity can make debt-to-equity ratios unstable or meaningless.
Debt-to-equity example
A company has bank loans of 600,000 CU, debentures of 300,000 CU and equity of 750,000 CU.
Debt-to-equity is:
(600,000 + 300,000) ÷ 750,000 × 100 = 120%
Debt exceeds equity, but interpretation requires cash-flow, asset and covenant information.
Debt-to-capital example
Using the same figures:
900,000 ÷ (900,000 + 750,000) × 100 = 54.5%
This expresses debt as a proportion of total long-term financing.
Interest cover
If operating profit is 270,000 CU and finance costs are 90,000 CU:
Interest cover = 270,000 ÷ 90,000 = 3 times
A falling ratio indicates reduced headroom, but fixed thresholds are not universally appropriate.
Why high gearing increases risk
- interest and principal payments are contractual;
- profit volatility has a larger effect on equity returns;
- covenant breaches can restrict operations or trigger repayment;
- refinancing may become difficult during market stress;
- credit ratings and borrowing costs may weaken.
Potential benefits of debt
- debt can be cheaper than equity;
- interest may receive tax deductions under local law;
- owners can retain control;
- stable cash-generating assets may support efficient leverage;
- moderate debt can increase equity returns when operating returns exceed borrowing cost.
Industry and asset structure
Utilities and property businesses may sustain more debt because cash flows or tangible security are stronger. Early-stage, cyclical or intangible-asset businesses may need lower gearing.
Benchmark only against genuinely comparable companies.
Cash flow versus accounting profit
Interest cover uses profit, but debt is paid with cash. Review operating cash flow, free cash flow, capital expenditure, working capital and maturity schedules.
Use the cash-flow linkage guide.
Net debt
Net debt deducts cash from gross debt, but not all cash is freely available. Restricted cash, overseas cash, minimum operating balances and trapped funds may require adjustment.
Lease liabilities
Including lease liabilities can materially increase debt. Compare ratios consistently and explain whether lease liabilities are included.
Lease-intensive businesses may need separate operating metrics and covenant definitions.
Debt maturity profile
A business can have moderate total debt but severe refinancing risk if large amounts mature soon. Analyse maturities, fixed versus variable rates, secured debt, currencies and covenant tests.
Covenants
Loan agreements may specify leverage, interest cover, net worth or liquidity thresholds using contractual definitions that differ from published ratios.
Reconcile covenant calculations to accounting records and forecast compliance under downside scenarios.
Effect on shareholders
Debt magnifies changes in returns to equity holders. When operating profit rises, fixed interest allows more upside to equity. When profit falls, the same fixed charge magnifies downside risk.
Review debenture accounting and dividend accounting for financing consequences.
Connection to broader ratio analysis
Gearing should be interpreted with profitability, liquidity and efficiency. Strong margins do not guarantee debt service when cash is tied up in inventory or receivables.
See the financial ratio analysis guide.
Stress-testing checklist
- reduce revenue and margins;
- increase interest rates;
- delay receivable collection;
- assume refinancing is unavailable;
- model covenant headroom;
- include capital expenditure and tax;
- consider currency and collateral exposure.
Fixed and floating interest rates
Floating-rate debt exposes future finance costs to benchmark-rate changes. Fixed-rate debt provides payment certainty but can create refinancing or fair-value considerations.
Stress testing should model rate resets, hedge effectiveness and maturity dates rather than applying one uniform interest assumption.
Currency risk
Debt denominated in a currency different from operating cash flows can increase repayment risk. Analyse natural hedges, derivatives, translation effects and access to the required currency.
Secured and unsecured debt
Security can reduce lender risk and borrowing cost but restrict asset use and recovery options. Review collateral values, priority, guarantees and cross-default terms.
Common mistakes
- comparing ratios calculated with different debt definitions;
- using closing balances for a highly seasonal company without context;
- ignoring lease liabilities and guarantees;
- deducting restricted cash from debt;
- assuming one gearing threshold fits every industry;
- relying on interest cover without cash-flow analysis;
- ignoring maturities and covenants.
Key takeaway
Debt and gearing ratios measure financing risk, not just borrowing size. Define debt consistently and combine leverage, interest cover, cash flow, maturities and covenants.
Official learning references: ACCA ratio analysis, ACCA gearing and performance appraisal, and ACCA sources of finance.