Solvency Ratios (Cambridge International A-Level Accounting)

What are solvency ratios?

• Solvency ratios assess a business's long-term financial health by measuring its ability to meet long-term obligations

  • They look at debt repayments and interest payments

• You need to know the following solvency ratios:

  • Interest cover
  • Gearing ratio

Interest cover

Spec point — how to calculate the following ratios: – interest cover

Interest cover

What is interest cover?

• The following is a rough guide to interpret the value

  • Above 3 times means the business can comfortably cover the interest
  • Between 2 and 3 times means it is acceptable but it might be tight
  • Between 1 and 2 times means the business is at risk of being unable to manage its debts
  • Below 1 times means the business is making a loss after interest

Worked Example T plc provides the following information for the year ended 31 December 2025.

	$
Profit before tax	115 000
8% debentures (repayable 2030)	250 000
10% bank loan (repayable 2035)	150 000

Calculate, to two decimal places, the interest cover ratio of T plc at 31 December 2025.

Answer:

• Calculate the debenture interest

8% × $250 000 = $20 000

• Calculate the bank loan interest

10% × $150 000 = $15 000

• Add together

$20 000 + $15 000 = $35 000

• Add the interest to the profit before tax to find the profit from operations

$115 000 + $35 000 = $150 000

• Calculate the interest cover

  • $\frac{\mathrm{Profit} \mathrm{from} \mathrm{operations}}{\mathrm{Interest} \mathrm{payable}}$

$\frac{150000}{35000}=4.285714...$

• Round to two decimal places

Final answer: 4.29 times

Gearing ratio

Spec point — how to calculate the following ratios: – gearing ratio

Gearing ratio

What is the gearing ratio?

• If the ratio is below 50%, then the company is low geared and is primarily equity financed

  • It is a lower financial risk to lenders

• If the ratio is above 50%, then the company is high geared and is primarily debt financed

  • It is a higher financial risk to lenders
  • The company might struggle to borrow additional funds

• If the gearing ratio increases then:

  • the company is increasing its reliance on debt
  • the amount of interest that the company needs to pay is increasing

Exam Hint The official formula might look confusing, so it might be easier to think of it as

$\frac{\mathrm{Non}-\mathrm{current} \mathrm{liabilities}}{\mathrm{Capital} \mathrm{employed}}\times100$

You know from the ROCE ratio that the capital employed is just the equity plus the non-current liabilities.

Worked Example T plc provides the following information for the year ended 31 December 2025.

	$
8% debentures (repayable 2030)	250 000
10% bank loan (repayable 2035)	150 000
Ordinary share capital	500 000
Share premium	60 000
Revaluation reserve	30 000
Retained earnings	20 000
Bank overdraft	5 000

Calculate, to two decimal places, the gearing ratio of T plc at 31 December 2025.

Answer:

• Calculate the total non-current liabilities

$250 000 + $150 000 = $400 000

• Calculate the capital employed

$500 000 + $60 000 + $30 000 + $20 000 + $400 000 = $1 010 000

• Calculate the gearing ratio

  • $\frac{\mathrm{Fixed} \mathrm{cost} \mathrm{capital}}{\mathrm{Total} \mathrm{capital}}\times100$

$\frac{400000}{1010000}\times100=39.603960...$

• Round to two decimal places

Final answer: 39.60%