NASAA Series 66 Uniform Combined State Law ExaminationEconomic Factors and Business InformationHard
An analyst is evaluating the financial health of a manufacturing company. The company has a debt-to-equity ratio of 1.5, indicating it uses $1.50 of debt for every $1.00 of equity. If the industry average for this ratio is 0.8, what does the company's ratio primarily suggest compared to its peers?
- ALower operational efficiency.
- BGreater financial leverage and risk.
- CStronger liquidity position.
- DHigher profitability.
Show answer & explanationAnswer & explanation
Correct answer: B. Greater financial leverage and risk.
A debt-to-equity ratio of 1.5, significantly higher than the industry average of 0.8, indicates that the company relies more heavily on debt financing relative to equity. This implies greater financial leverage, which can amplify both returns and risks, as higher debt levels typically lead to increased interest payments and a higher risk of default.
Why the other options are wrong
- A. Operational efficiency is typically measured by ratios like asset turnover or inventory turnover, not the debt-to-equity ratio.
- C. Liquidity refers to a company's ability to meet short-term obligations, measured by ratios like current or quick ratio, not debt-to-equity.
- D. While higher leverage can amplify returns, it doesn't automatically mean higher profitability; it also means higher risk. The ratio itself doesn't directly measure profitability.
Debt-to-Equity Ratio
A solvency ratio that indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.
- Formula: Total Liabilities / Shareholder Equity.
- Higher ratio implies greater financial leverage and risk.
- Lower ratio indicates less reliance on debt.
Memory trick: Debt-to-Equity: Digging Deep in Debt.