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How do gearing and investor ratios measure financial risk and the returns available to shareholders?

Calculate and interpret the gearing ratio, interest cover, earnings per share and dividend cover

A focused answer to the H2 Principles of Accounting outcome on gearing and investor ratios. The gearing ratio, interest cover, earnings per share and dividend cover, the meaning of financial risk, and how investors read them.

Generated by Claude Opus 4.810 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to calculate and interpret gearing and investor ratios: the gearing ratio and interest cover (which measure financial risk) and earnings per share and dividend cover (which measure shareholder returns). These ratios sit at the intersection of how a company is financed and what its owners get back. The central insight is that debt magnifies both returns and risk, so gearing measures how exposed a company is, while investor ratios translate profit into per-share terms that owners care about.

The answer

Gearing ratios (financial risk)

Ratio	Formula	Measures
Gearing ratio	$\dfrac{\text{debt}}{\text{debt} + \text{equity}} \times 100$	Proportion of long-term capital from debt
Interest cover	$\dfrac{\text{operating profit}}{\text{finance costs}}$	How many times profit covers interest

A highly geared company (high debt proportion) carries more financial risk: interest must be paid regardless of profit, so a downturn can quickly threaten solvency. Interest cover shows the safety margin; a high cover means profit comfortably services the debt.

Investor ratios (shareholder returns)

Ratio	Formula	Measures
Earnings per share (EPS)	$\dfrac{\text{profit for the year}}{\text{number of ordinary shares}}$	Profit earned per share
Dividend cover	$\dfrac{\text{profit for the year}}{\text{dividends}}$	How many times the dividend is covered by profit

EPS expresses the bottom line per share, letting shareholders compare returns across companies and years. Dividend cover shows how sustainable the dividend is: a high cover means much profit is retained (safe but less paid out); a low cover means most profit is distributed (generous but fragile).

Why gearing cuts both ways

Debt is cheaper than equity (interest is tax-relievable and lenders accept a lower return than owners), so moderate gearing can boost returns to shareholders. But the fixed interest obligation increases risk: in a poor year, interest still falls due while dividends can be cut. The art of interpretation is judging whether the gearing is prudent for the company's profit stability.

Worked example

A company reports: debt (non-current liabilities) $\$ 500,000 $; equity$ \ $500\,000$ ; operating profit $\$ 150,000 $; finance costs$ \ $50\,000$ ; profit for the year $\$ 70,000 $;$ 700,000 $ordinary shares; dividends$ \ $35\,000$ . Calculate all four ratios and assess.

Step 1: Gearing ratio

\frac{500\,000}{500\,000 + 500\,000} \times 100 = 50\%

Step 2: Interest cover

\frac{150\,000}{50\,000} = 3 \text{ times}

Step 3: EPS and dividend cover

EPS $= \dfrac{70\,000}{700\,000} = \$ 0.10 $per share. Dividend cover$ = \dfrac{70,000}{35,000} = 2 \text{ times}$.

Step 4: Assess

At $50\%$ gearing the company is fairly highly geared, so financial risk is significant. Interest cover of $3$ times gives a reasonable but not generous safety margin. EPS of $\$ 0.10 $and dividend cover of$ 2$ times mean half the profit is paid out and half retained, a sustainable balance. The overall picture is a company using debt aggressively but still servicing it adequately, a judgement that depends on how stable its profits are.

Examples in context

Example 1. A downturn hits a highly geared firm. A company with $70\%$ gearing and interest cover of just $1.5$ times faces a recession. Operating profit falls, and because interest is fixed, interest cover drops below $1$ , meaning profit no longer covers the interest. The high gearing that boosted returns in good times now threatens solvency, illustrating exactly why these ratios measure financial risk.

Example 2. Comparing two companies for investment. Two firms have similar profits, but one has EPS of $\$ 0.40 $and dividend cover of$ 4 $times, the other EPS of$ \ $0.40$ and cover of $1.1$ times. The first retains more profit and offers a safer dividend; the second pays out almost everything, attractive for income but riskier. The investor ratios let a shareholder weigh income against sustainability, which the raw profit figure cannot.

Try this

Q1. Debt is $\$ 300,000 $and equity is$ \ $700\,000$ . Find the gearing ratio. [2 marks]

Cue. $\dfrac{300\,000}{300\,000 + 700\,000} \times 100 = 30\%$ .

Q2. Operating profit is $\$ 80,000 $and finance costs are$ \ $20\,000$ . Find interest cover and comment. [2 marks]

Cue. $\dfrac{80\,000}{20\,000} = 4 \text{ times}$ ; profit covers interest four times, a comfortable margin.

Q3. Explain why a highly geared company is riskier in a downturn. [3 marks]

Cue. Interest on debt is a fixed obligation that must be paid regardless of profit; when profit falls, interest cover shrinks and the company may be unable to service its debt, whereas dividends could have been cut.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original7 marksA company has non-current liabilities (debt) of

\

400\,000

, equity of

600\,000

, operating profit of

\

120\,000

and finance costs of

30\,000

. (a) Calculate the gearing ratio and interest cover. (b) Comment on the company's financial risk.

Show worked answer →

(a) Gearing ratio $= \dfrac{\text{debt}}{\text{debt} + \text{equity}} \times 100 = \dfrac{400\,000}{400\,000 + 600\,000} \times 100 = \dfrac{400\,000}{1\,000\,000} \times 100 = 40\%$ .

Interest cover $= \dfrac{\text{operating profit}}{\text{finance costs}} = \dfrac{120\,000}{30\,000} = 4 \text{ times}$ .

(b) A gearing ratio of $40\%$ means debt funds $40\%$ of the long-term capital, a moderate level. Interest cover of $4$ times means operating profit covers the interest four times over, a comfortable margin. The company carries some financial risk from its debt, but its profit comfortably services the interest, so the risk appears manageable.

Markers reward both ratios with formulae, the $40\%$ gearing and $4$ -times cover, and a balanced comment linking the figures to financial risk.

Original6 marksA company has profit for the year of

\

180\,000

,

600\,000

ordinary shares in issue, and paid dividends of

60\,000

. (a) Calculate the earnings per share and the dividend cover. (b) Explain what dividend cover tells a shareholder and the risk of a low figure.

Show worked answer →

(a) Earnings per share (EPS) $= \dfrac{\text{profit for the year}}{\text{number of ordinary shares}} = \dfrac{180\,000}{600\,000} = \$ 0.30 \text{ per share}$.

Dividend cover $= \dfrac{\text{profit for the year}}{\text{dividends}} = \dfrac{180\,000}{60\,000} = 3 \text{ times}$ .

(b) Dividend cover shows how many times the dividend could have been paid out of the year's profit. A cover of $3$ times means only one third of profit was distributed, leaving two thirds retained, a sustainable position. A low dividend cover (near $1$ or below) means most or all profit is paid out, leaving little retained; the dividend is then vulnerable to any fall in profit and the company has less to reinvest.

Markers reward EPS of $\$ 0.30 $, dividend cover of$ 3$ times, the interpretation of cover as sustainability, and the risk that a low cover makes the dividend fragile.