1. Capital Structure Decisions
Solvency ratios analyze a business’s long-term funding mix. They focus heavily on Gearing (Financial Leverage), which measures the balance between debt capital (borrowed from banks) and equity capital (invested by owners).
2. Core Solvency Formulas
- Debt-to-Equity Ratio: Compares total debt directly to owner investments.
“Debt-to-Equity (D/E)” = “Total Long-Term Debt”/”Total Equity”
- Gearing Ratio: Measures long-term debt as a percentage of the company’s total capital base.
Gearing Ratio (%)=Long-Term DebtTotal Capital Employed (Equity + Debt)×100
- Interest Coverage Ratio: Measures safety margins by showing how many times over a company’s operating profits can cover its annual loan interest obligations.
Interest Coverage=Operating Profit (EBIT)Finance Costs (Interest Expense)
3. Gearing Risk Dynamics
- High Gearing (>50%): Increases financial risk. The business must make fixed interest payments regardless of its sales performance, leaving it vulnerable during economic downturns.
- Low Gearing: Reduces default risks but can indicate a conservative management team that is missing opportunities to use debt to fund faster growth.