You have found the perfect opportunity: new machinery that will increase capacity by 40%, or a new depot that lets you win that big contract. You approach your bank for a £300,000 loan, confident the numbers stack up. But the lender comes back with a list of ratios you have never heard of — interest cover, gearing — and either knocks back the application or offers a much smaller facility than you asked for. If you do not understand how these ratios work, you are negotiating blind, and you risk either being turned down for finance you could genuinely afford, or taking on debt that quietly puts your business at risk. This article explains exactly what lenders are looking at, how to calculate it yourself before you apply, and what you can do if the numbers are not strong enough yet.
Why Lenders Care About These Two Numbers
Every time a bank or lender considers lending you money, they are asking one question in two different ways: if things go wrong, will we get our money back? Interest cover answers the short-term version of that question — can your trading profit comfortably pay the interest you owe, month after month? Gearing answers the longer-term version — how much of your business is already funded by debt rather than by you and your shareholders, and how much headroom is left before the balance tips too far towards risk. Lenders do not ask for these numbers to catch you out. They are standard tests built into almost every loan agreement, often as ongoing covenants you must keep meeting even after the money lands in your account.
Interest Cover, in Plain English
Interest cover tells you how many times over your business could pay its interest bill out of trading profit. You calculate it by dividing operating profit (sometimes called EBIT — earnings before interest and tax) by your interest expense for the same period. A ratio of 5 means your profit could cover your interest five times over, so even if profit dropped sharply you would likely still manage the payments. A ratio close to 1 means almost all your operating profit is being swallowed by interest, leaving razor-thin room for any dip in trading. Most lenders want to see interest cover of at least 2 to 3 times before they will lend, and many want considerably more for anything beyond a modest facility.
Gearing, in Plain English
Gearing measures how much of your business is financed by borrowing compared with how much is financed by the owners’ own money — share capital plus retained profits, known as equity. A business with £500,000 of debt and £500,000 of equity has gearing of 100%: debt and equity are equal. A business with £200,000 of debt and £800,000 of equity has gearing of 25% — much less reliant on borrowed money. High gearing is not automatically bad; well-run companies with reliable cash flow can carry significant debt. But the higher your gearing, the less cushion you have if trading dips, and the more nervous lenders become about adding further debt on top.
Quick reference: Interest cover = Operating profit ÷ Interest expense. Gearing = Total debt ÷ Equity (or sometimes Total debt ÷ (Debt + Equity), depending on which version your lender uses — always check which formula applies to your specific loan covenant before you calculate your own figures).
Worked Example: ABC Manufacturing Ltd
ABC Manufacturing Ltd turns over £2.4 million a year and wants to borrow £300,000 to buy new machinery, repayable over seven years at a fixed interest rate of 6%. Before approaching the bank, the finance manager pulls together the current numbers and models what the business will look like once the new loan is in place, so there are no surprises in the meeting.
| Before New Loan | After New Loan | |
|---|---|---|
| Operating profit (EBIT) | £180,000 | £180,000 |
| Existing interest expense | £25,000 | £25,000 |
| New loan interest (6% of £300,000) | — | £18,000 |
| Total interest expense | £25,000 | £43,000 |
| Existing debt | £200,000 | £200,000 |
| New loan | — | £300,000 |
| Total debt | £200,000 | £500,000 |
| Equity (share capital and reserves) | £650,000 | £650,000 |
| Interest cover before (£180,000 ÷ £25,000) | 7.2x |
| Interest cover after (£180,000 ÷ £43,000) | 4.19x |
| Gearing before (£200,000 ÷ £650,000) | 30.8% |
| Gearing after (£500,000 ÷ £650,000) | 76.9% |
Both ratios move in the wrong direction once the new loan is added, but neither figure is alarming on its own. Interest cover of 4.19 times is still comfortably above the 2 to 3 times threshold most lenders apply, meaning ABC’s trading profit would need to fall by more than 75% before interest payments became a real problem. Gearing of 76.9% is higher than many lenders prefer to see, but it is not unusual for a manufacturing business that has just invested in new equipment, provided cash flow remains strong and profit is trending upward rather than flat or falling.
| Account | Dr | Cr |
|---|---|---|
| Bank | £300,000 | |
| Long-term loan | £300,000 |
Drawdown of the new £300,000 term loan from the bank for machinery purchase.
| Account | Dr | Cr |
|---|---|---|
| Interest expense | £1,500 | |
| Accrued interest payable | £1,500 |
Monthly accrual of interest on the new loan (6% annual rate ÷ 12 months × £300,000).
If your loan agreement includes covenants based on interest cover or gearing, breaching them even by a small margin can trigger serious consequences — lenders can demand immediate repayment, increase your interest rate, or impose new restrictions on dividends and further borrowing. Always build a margin of safety into your calculations rather than borrowing right up to the threshold, and recalculate your ratios whenever you take on new finance, lose a major customer, or revise your profit forecast downward.
What This Means for Your Business
If your own numbers look like ABC’s — a healthy interest cover but gearing creeping towards or past 75% to 100% — you still have options. You could negotiate a lower interest rate to reduce the annual interest charge, extend the loan term to ease monthly principal repayments, inject additional equity from the owners to strengthen the balance sheet, phase the investment so you borrow in two smaller tranches rather than one large one, or simply wait until a strong trading year has lifted retained profits and reduced your reliance on debt. None of these ratios are pass-or-fail tests applied once and forgotten; most lenders will check them again at each year end or quarter as part of your loan covenants, so the real skill is managing them on an ongoing basis, not just at the point of application.
- Calculate your own interest cover and gearing before you approach a lender, using the same formulas they will use, so you know what to expect and can address weak points in advance.
- Build in a safety margin — aim for interest cover comfortably above 3 times and gearing below 100%, so a drop in trading profit does not push you into a covenant breach.
- If your numbers are borderline, consider negotiating a lower interest rate to reduce annual interest, extending the loan term to lower annual principal repayments, injecting additional equity, or phasing the investment to borrow less at once.
- Review your ratios every quarter once debt is in place, not just at the point of borrowing, so you can act early if trading conditions change and covenants come under pressure.
Need help reading the numbers lenders will see?
We help SME owners and finance teams understand their own financial reports before the bank does, so you walk into every lending conversation prepared, with your ratios calculated and your options already mapped out.
