Chartered Financial Analyst (CFA) Level 1 Practice Exam

What do leverage ratios assess?

1. The degree to which managers use debt or equity to finance assets

2. The return on equity of a company

3. The liquidity position of a company

4. The absolute level of a company's assets

The correct answer is: The degree to which managers use debt or equity to finance assets

Leverage ratios specifically assess the extent to which a company utilizes debt in its capital structure compared to other forms of financing, primarily equity. These ratios provide insight into the financial leverage employed by the company, which indicates the risk level associated with its capital financing strategy. A high leverage ratio suggests that a company relies more on borrowed funds, which may increase potential returns on equity but also exposes the company to greater financial risk during downturns. For instance, ratios such as the debt-to-equity ratio and debt ratio illustrate the proportion of debt relative to equity. This information is crucial for investors and creditors as it helps evaluate the company’s risk profile and its ability to meet financial obligations. In contrast, assessment of return on equity relates to profitability, liquidity ratios evaluate a company's ability to meet short-term obligations, and asset levels do not directly indicate how financing decisions are made. Understanding leverage ratios is essential for comprehending the broader implications of a company's financial health and investment strategy.