Certified Financial Management Specialist Practice Exam

In financial analysis, how can a high leverage ratio affect growth rates?

1. It leads to slower growth

2. It may lead to higher growth rates

3. It has no effect on growth rates

4. It guarantees steady growth

The correct answer is: It may lead to higher growth rates

A high leverage ratio typically indicates that a company is using a significant amount of debt relative to its equity. This can lead to higher growth rates for several reasons. When a company takes on debt, it can use the borrowed funds to invest in business opportunities such as expanding operations, purchasing new technology, or increasing marketing efforts. These investments can generate additional revenues that may exceed the costs associated with the debt, thereby enhancing growth. Moreover, if the investments funded by debt are successful, the company may experience an increase in its returns on equity, as profits are generated from using less equity in the capital structure. This scenario can lead to a perception of growth and financial viability in investors' eyes, potentially resulting in a higher market valuation. It's important to note that while high leverage can facilitate growth through increased investment capacity, it comes with risks, such as higher interest obligations and the potential for financial distress if the company cannot meet its debt obligations. However, the direct relationship between high leverage and the potential for higher growth rates underpins the correctness of this answer choice.