Financial Analysis: Solvency, Gearing and Investors’ Ratios

Profitability and liquidity tell how a business is doing now. Solvency asks whether it will still be standing in a bad year, and the investors’ ratios ask what the shareholders get for the risk. The first depends mainly on how much of the business is financed by debt.

Debt is cheaper than equity when the business is doing well, because interest is fixed and the profit above it belongs to the shareholders. But it must be paid whether or not the business does well.

This topic covers the gearing ratios and interest cover, which measure that risk, and the investors’ ratios: earnings per share, the price-earnings ratio, dividend yield and dividend cover, with a worked interpretation using the Zaria Plc figures. The next topic shows how to bring the ratios together in an analysis and a report.

The investors’ ratios are examined in the performance questions. In May Diet, 2026, Question 3 (20 marks) asked for return on capital employed, earnings per share, dividend per share, dividend cover and asset turnover over four years (5 marks), and then for advice to an investor on whether to subscribe to a new issue of shares (4 marks). Read working capital efficiency and liquidity first.

Solvency and gearing

Gearing (leverage) measures the long-term debt of a company as a percentage of either the equity or the total long-term capital:

• Debt to equity = long-term debt ÷ share capital and reserves × 100.
• Gearing ratio = long-term debt ÷ (share capital and reserves + long-term debt) × 100.

Preference shares are normally included in debt capital. The figures are usually the year-end balances, although averages may be used. For Zaria: Year 2, debt to equity 330 ÷ 720 = 45.8%, gearing 330 ÷ (720 + 330) = 31.4%; Year 1, 250 ÷ 657 = 38.1% and 250 ÷ 907 = 27.6%.

A company is highly geared when its debt exceeds its equity, so the gearing ratio is above 50% (or above 100% on debt to equity), and low geared when it is below. A high level of gearing may indicate that the company will find it hard to borrow more, and that there is a risk it will be unable to meet payments to lenders when they fall due.

What is high or low depends on the type of business: companies with large physical assets, such as property companies, can offer security and borrow more; companies with few physical assets, such as advertising businesses, usually borrow less. For a group, use consolidated figures, with the non-controlling interest included in equity.

Interest cover

Interest cover = profit before interest and tax (PBIT) ÷ interest charges for the year. It shows how many times the profit covers the interest. Zaria: Year 2 180 ÷ 30 = 6.0 times; Year 1 160 ÷ 20 = 8.0 times. A low cover suggests too much debt in relation to profit. Zaria’s cover has fallen, but at 6 times it is comfortable.

The effect of gearing on the owners

Debt cost Zaria 30 ÷ 330 = 9.1% a year, while the business earned a return on capital employed (ROCE) of 17.1%. The shareholders benefit from the difference, so the gearing is working in their favour. If the ROCE fell below the cost of debt, the same gearing would reduce the shareholders’ return and, with a fixed obligation, increase the risk of failure.

The more highly geared the company, the larger the swing in profit for the owners with each change in operating profit.

Investors’ ratios

• Earnings per share. (EPS) = profit after tax and preference dividends (and non-controlling interest) ÷ the weighted average number of ordinary shares.
  Zaria: Year 2 ₦105m ÷ 200m = 52.5 kobo
  Year 1 ₦98m ÷ 200m = 49.0 kobo.
• Price-earnings ratio. (P/E) = market price per share ÷ earnings per share.
  At ₦6.30 the P/E is 6.30 ÷ 0.525 = 12.0.
  A P/E of 12 means investors are prepared to pay twelve years of current earnings for a share.
  A high P/E is usually a sign of confidence in future growth; a low P/E suggests poor prospects.
• Dividend per share.
  dividends ÷ number of shares: Year 2 ₦42m ÷ 200m = 21.0 kobo
  Year 1 ₦39m ÷ 200m = 19.5 kobo.
• Dividend yield.
  dividend per share ÷ market price per share × 100.
  0.21 ÷ 6.30 = 3.3%.
  It is the return the shareholder receives in cash in relation to the price.
  It reflects the dividend policy, which is a decision of management, and the price may move, so the yield alone is not a measure of performance.
• Dividend cover.
  earnings per share ÷ dividend per share, or earnings ÷ dividends: 105 ÷ 42 = 2.5 times
  Year 1 98 ÷ 39 = 2.5 times.
  A low cover, for example less than 2, suggests the dividend may be cut if profit falls.
  A very high cover means that the company retains most of its profit, which may fund growth.

Zaria’s earnings per share rose by 7%, the dividend per share by 8%, and the cover is unchanged at 2.5 times, so the dividend looks safe. A potential investor would look at the P/E in relation to the sector and to the company’s growth.

The ideas in more depth

Why gearing is a risk and an opportunity

Interest is a fixed charge. When operating profit is high, the owners keep everything above it; when it falls, the interest still has to be paid. That magnifies the swings in the owners’ profit in both directions.

Why dividend yield and cover say different things

The yield compares the cash dividend with the price, so it tells an investor what income the shares provide. The cover compares the dividend with earnings, so it tells how safe that dividend is. A high yield with a low cover can mean that the market expects a cut.

Sources and references

• International Accounting Standard (IAS) 33 Earnings per Share, for the earnings per share figure; the gearing, cover, yield and price-earnings ratios are conventional analytical measures and are not defined by a standard.

These points are stated as at 5 November 2026.

Worked examples

1. Gearing.
   330 ÷ (720 + 330) = 31.4%
   debt to equity 330 ÷ 720 = 45.8%.
2. Interest cover.
   180 ÷ 30 = 6.0 times.

1. EPS.
   52.5 kobo; P/E 6.30 ÷ 0.525 = 12.0.
2. dividend per share (DPS)
   21.0 kobo; yield 3.3%; cover 105 ÷ 42 = 2.5 times.

1. Comparison. 12% exceeds 9%, so each naira of debt earns more than it costs, and the owners benefit.
2. Risk. If ROCE fell to 7%, below the cost of debt, gearing would reduce the owners’ return.

How to answer in the exam

• State which gearing formula you use and include preference shares in debt.
• Calculate over the years given and comment on trends.
• For an investor, compare earnings, dividends and cover with the price, and mention growth and risk.
• Give a recommendation and qualify it with non-financial factors.

Common mistakes in the exam

• Leaving preference shares out of debt.
• Using the number of shares at the year end when the weighted average number is needed.
• Mixing up dividend yield and dividend cover.
• Calling a company highly geared without saying which measure applies.
• Not comparing the cost of debt with the return on capital employed.
• Giving a recommendation without any caveats.

Quick revision

• Gearing = debt ÷ (debt + equity), or debt ÷ equity. Interest cover = PBIT ÷ interest.
• EPS, P/E = price ÷ EPS, yield = DPS ÷ price, cover = EPS ÷ DPS.
• High gearing: more risk; helps owners only if ROCE exceeds the cost of debt.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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