Certified Financial Management Specialist Practice Exam

What does the debt-to-equity (D/E) ratio help to determine?

1. Profitability of a company

2. Riskiness of a company's borrowing practices

3. Market share of a company

4. Liquidity of a company's assets

The correct answer is: Riskiness of a company's borrowing practices

The debt-to-equity (D/E) ratio is a financial metric that measures a company’s financial leverage by comparing its total liabilities to its shareholders' equity. It is calculated using the formula: Total Liabilities / Shareholders' Equity. This ratio helps to determine the riskiness of a company's borrowing practices. A higher D/E ratio indicates that a company is financing a significant portion of its operations through debt, which may increase financial risk. If the D/E ratio is low, it suggests that the company is relying more on equity financing, which typically implies less risk. Investors and creditors use this ratio to assess the firm's debt levels in relation to its equity and to evaluate how much risk they might be undertaking. While the other options touch upon important aspects of a company's financial health, they do not precisely relate to the specific function of the D/E ratio. Profitability pertains to the company's ability to generate earnings, market share focuses on sales relative to competitors, and liquidity assesses how easily a company's assets can be converted to cash. The D/E ratio distinctly centers on understanding the relative proportions of debt and equity, highlighting the company’s financial leverage and the associated risk.