Chartered Financial Analyst (CFA) Level 1 Practice Exam

What does the debt-to-equity ratio measure?

1. Total debt in relation to total market value

2. Total debt in relation to shareholder's equity

3. Total liabilities in relation to current assets

4. Total assets in relation to total liabilities

The correct answer is: Total debt in relation to shareholder's equity

The debt-to-equity ratio is a key financial metric that assesses a company's financial leverage by comparing its total liabilities to its shareholders' equity. This ratio indicates how much debt a company is using to finance its assets relative to the equity contributed by its shareholders. A higher debt-to-equity ratio suggests that a company is financing a larger portion of its operations through debt, which can increase financial risk, particularly during periods of economic downturn or rising interest rates. Conversely, a lower ratio signifies a more conservative capital structure with less reliance on debt. Understanding this ratio is crucial for investors and analysts as it provides insight into the risk associated with a company's capital structure. Companies with high debt levels may face challenges in meeting their financial obligations, while those with lower debt levels may be more stable and less vulnerable to fluctuations in their financial environment.