Chartered Financial Analyst (CFA) Level 1 Practice Exam

How is the financial leverage ratio defined?

1. Net income / Average total equity

2. Average total assets / Average total equity

3. Total Debt / Total Assets

4. Total Assets / Average total equity

The correct answer is: Average total assets / Average total equity

The financial leverage ratio is defined as the average total assets divided by the average total equity. This ratio measures the proportion of a company's assets that are financed by shareholders' equity, reflecting the degree of financial leverage being used. When this ratio is greater than one, it indicates that the company is using more debt than equity to finance its assets, which can amplify both potential returns and risks. In the context of financial analysis, understanding how much of a company's capital structure is comprised of debt versus equity is crucial for assessing its financial health and risk profile. High financial leverage can lead to increased returns during good economic times, but it also increases the risk of financial distress during downturns. The other choices represent different financial metrics that do not accurately capture the essence of financial leverage. For example, ratios that involve only net income or total debt relative to total assets do not provide the same insight into how a company uses its equity to support its asset base. Hence, the correct determination of financial leverage lies in the relationship between total assets and equity, as highlighted by the correct answer.