Which type of financial ratio can reveal that a company is relying too much on borrowed money?

• A. Inventory turnover ratio
• B. Current ratio
• C. Gross profit margin
• D. Debt-to-equity ratio

Answer: (D)

Verified step by step guidance

1. Understand the concept of financial ratios: Financial ratios are tools used to evaluate a company's financial health and performance. Each ratio provides insights into specific aspects of the company's operations or financial structure.
2. Learn about the debt-to-equity ratio: This ratio measures the proportion of debt financing relative to equity financing in a company. It is calculated using the formula: $\frac{\mathrm{Debt}}{\mathrm{Equity}}$. A high debt-to-equity ratio indicates that a company is relying heavily on borrowed money.
3. Compare the debt-to-equity ratio with other ratios: Inventory turnover ratio measures how efficiently inventory is managed, current ratio assesses short-term liquidity, and gross profit margin evaluates profitability. None of these directly indicate reliance on borrowed money like the debt-to-equity ratio does.
4. Interpret the implications of a high debt-to-equity ratio: If the ratio is significantly high, it suggests that the company may face higher financial risk due to its dependence on debt financing. This could lead to challenges in meeting interest obligations or maintaining financial stability during economic downturns.
5. Apply this knowledge to analyze financial statements: When reviewing a company's financial statements, calculate the debt-to-equity ratio to assess its reliance on borrowed money. Use this ratio alongside other financial metrics to form a comprehensive understanding of the company's financial health.