Which of the following is a ratio used to evaluate a company's solvency?

• A. Gross Profit Margin
• B. Inventory Turnover Ratio
• C. Current Ratio
• D. Debt to Equity Ratio

Answer: (D)

Verified step by step guidance

1. Understand the concept of solvency: Solvency refers to a company's ability to meet its long-term obligations and sustain operations over the long term. Ratios used to evaluate solvency focus on the relationship between a company's debt and equity or its ability to cover long-term liabilities.
2. Review the given options: Gross Profit Margin, Inventory Turnover Ratio, Current Ratio, and Debt to Equity Ratio. Each of these measures different aspects of a company's financial health.
3. Eliminate irrelevant options: Gross Profit Margin measures profitability, not solvency. Inventory Turnover Ratio evaluates how efficiently inventory is managed, which is unrelated to solvency. Current Ratio measures liquidity, focusing on short-term obligations rather than long-term solvency.
4. Focus on the Debt to Equity Ratio: This ratio is specifically designed to assess solvency by comparing a company's total liabilities to its shareholders' equity. It is calculated using the formula: $\frac{\mathrm{Total} \mathrm{Liabilities}}{\mathrm{Shareholders}\text{'}\mathrm{Equity}}$. A higher ratio indicates greater reliance on debt, which may signal lower solvency.
5. Conclude that the Debt to Equity Ratio is the correct answer because it directly evaluates a company's solvency by analyzing the proportion of debt financing relative to equity financing.