Total Liabilities divided by Total Equity is used to calculate which ratio?

Total Liabilities divided by Total Equity is used to calculate which ratio?

• A. DEBT-TO-EQUITY RATIO CALCULATION
• B. CURRENT RATIO
• C. QUICK RATIO
• D. RETURN ON INVESTMENT

Answer: (A)

The concept being tested is leverage—how much debt a company has relative to the funds invested by owners. The ratio that uses total liabilities divided by total equity is the debt-to-equity ratio. It shows how many dollars of debt exist for each dollar of equity. A higher debt-to-equity ratio signals greater leverage and higher risk for creditors and investors, because more obligations must be serviced from earnings regardless of how well the business is performing. This isn’t the same as liquidity ratios like the current ratio (current assets divided by current liabilities) or the quick ratio (quick assets divided by current liabilities), which focus on a company’s ability to meet short-term obligations. It also isn’t a profitability measure like return on investment, which looks at earnings relative to the amount invested, not the balance between what’s owed and what owners have put in.

The concept being tested is leverage—how much debt a company has relative to the funds invested by owners. The ratio that uses total liabilities divided by total equity is the debt-to-equity ratio. It shows how many dollars of debt exist for each dollar of equity. A higher debt-to-equity ratio signals greater leverage and higher risk for creditors and investors, because more obligations must be serviced from earnings regardless of how well the business is performing.

This isn’t the same as liquidity ratios like the current ratio (current assets divided by current liabilities) or the quick ratio (quick assets divided by current liabilities), which focus on a company’s ability to meet short-term obligations. It also isn’t a profitability measure like return on investment, which looks at earnings relative to the amount invested, not the balance between what’s owed and what owners have put in.