Certified Financial Management Specialist Practice Exam

Which of the following is a metric used to evaluate a firm's capital structure?

1. Price-to-Earnings (P/E) ratio

2. Debt-to-Equity (D/E) ratio

3. Return on Investment (ROI)

4. Current Ratio

The correct answer is: Debt-to-Equity (D/E) ratio

The Debt-to-Equity (D/E) ratio is a crucial metric for evaluating a firm's capital structure because it provides insight into the proportion of debt financing versus equity financing that a company uses to fund its operations and growth. A high D/E ratio may indicate that a company relies more on borrowed funds, which can signify greater financial risk, especially if the firm faces downturns or challenges in generating revenue. Conversely, a lower D/E ratio suggests a more conservative approach with less reliance on debt, potentially indicating lower financial risk and greater operational stability. Understanding this ratio is essential for financial managers as it helps assess a firm's financial leverage and debt risk profile, allowing stakeholders to make informed decisions about investments and financing strategies. The D/E ratio is particularly valuable alongside other financial metrics to provide a comprehensive understanding of a company's financial structure and risk management practices. In contrast, other options like the Price-to-Earnings (P/E) ratio focus more on valuation and profitability, Return on Investment (ROI) measures the efficiency of an investment, and the Current Ratio assesses short-term liquidity. None of these metrics directly evaluate how a firm balances its debt and equity financing, making the D/E ratio the most relevant choice for analyzing capital structure.