Alabama Contractors License Practice Exam

What formula is used to determine the debt ratio?

1. liabilities/assets

2. assets/liabilities

3. income - cost of goods

4. profit - expenses

The correct answer is: liabilities/assets

The correct formula to determine the debt ratio is liabilities divided by assets. This ratio is crucial in assessing a company's financial leverage and stability. By calculating the debt ratio, you can see what portion of a company's assets are financed through debt. A higher debt ratio indicates that a larger portion of the company's assets are funded by borrowing, which can suggest higher financial risk if not managed properly. Conversely, a lower ratio suggests that a company is less reliant on borrowed funds, which can be seen as a sign of financial health. The other options reflect various financial metrics but do not pertain to the debt ratio. Dividing assets by liabilities would provide an inverse measure, indicating how many assets exist for every unit of liability, which doesn't give insight into financial risk. The third and fourth choices refer to profit calculations and are related to income statements rather than assessing financial leverage.