Chartered Financial Analyst (CFA) Level 1 Practice Exam

What do solvency ratios measure?

1. Ability to meet short-term obligations

2. Ability to service long-term obligations

3. Effectiveness of cash management

4. Efficiency of asset utilization

The correct answer is: Ability to service long-term obligations

Solvency ratios are financial metrics used to assess a company’s ability to meet its long-term obligations. They provide insight into the financial health of an organization and its capacity to sustain operations over the long run without running into solvency issues. The primary focus of these ratios is to evaluate whether a company has enough assets to cover its long-term debts and other financial commitments. When analyzing solvency ratios, investors and creditors look for indicators like the debt-to-equity ratio or the interest coverage ratio, which show the relationship between debt levels and equity as well as the sufficiency of operating income to cover interest payments. A strong solvency position indicates that a company is less likely to face financial distress, making it a more attractive investment or lending option. In contrast, the other choices focus on different financial aspects. The first option relates to liquidity and the ability to handle short-term obligations, which is the domain of liquidity ratios. The third option concerns cash management and its effectiveness in maintaining cash flow. Lastly, the fourth option addresses how efficiently a company utilizes its assets, which is assessed through efficiency ratios. Each of these areas is crucial, but they all serve different purposes within financial analysis, whereas solvency specifically targets long-term financial stability.