Chartered Financial Analyst (CFA) Level 1 Practice Exam

Which of the following ratios helps determine a company's financial leverage?

1. Retention rate

2. Cash flow to revenue

3. Debt to capital ratio

4. Current ratio

The correct answer is: Debt to capital ratio

The debt to capital ratio is a key measure that indicates the extent to which a company is utilizing debt to finance its operations compared to its overall capital structure, which includes both debt and equity. This ratio provides insight into a company's financial leverage by expressing the proportion of debt in relation to total capital. A higher ratio suggests that a company is more leveraged, relying more on debt for financing, which can amplify both returns and risks. It shows how much of the company’s capital is sourced from debt, making it crucial for assessing the financial risk associated with the firm's capital structure. The retention rate relates to how much profit a company retains versus how much is distributed to shareholders, rather than providing insights into leverage. Cash flow to revenue focuses on the efficiency of cash generation relative to sales, not specifically measuring leverage. The current ratio assesses a company's ability to meet its short-term obligations with its short-term assets, which is more about liquidity than leverage. Thus, the debt to capital ratio is the most relevant measure for understanding a company's financial leverage.