Financial Accounting Quiz: Leverage Ratios
20 questions · exam conditions
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Leverage RatiosQuestion 1 of 20

A company has total liabilities of $3,000,000. Its equity consists of $1,000,000 in common stock and a retained deficit of $1,500,000. Which statement best describes the company's debt-to-equity ratio?

The ratio is -2.0, indicating a highly solvent position.
The ratio is not a meaningful measure because stockholders' equity is negative.
The ratio is 3.0, calculated by using the absolute value of equity.
The ratio cannot be calculated because retained earnings are negative.
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Financial Accounting Quiz

Financial Accounting Quiz: Leverage Ratios

Practice Leverage Ratios in Financial Accounting with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Leverage Ratios, giving you a quick way to practice the rules, question types, and explanations that matter most for Financial Accounting.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A company has total liabilities of $3,000,000. Its equity consists of $1,000,000 in common stock and a retained deficit of $1,500,000. Which statement best describes the company's debt-to-equity ratio?

  1. The ratio is -2.0, indicating a highly solvent position.
  2. The ratio is not a meaningful measure because stockholders' equity is negative. (correct answer)
  3. The ratio is 3.0, calculated by using the absolute value of equity.
  4. The ratio cannot be calculated because retained earnings are negative.
Explanation: First, calculate total equity: Total Equity = Common Stock + Retained Earnings (Deficit) = $1,000,000 - 1,500,000=−1,500,000 = -500,000. A negative total equity indicates that liabilities exceed assets, meaning the company is insolvent. While the debt-to-equity ratio can be mathematically calculated as 3,000,000/−3,000,000 / -500,000 = -6.0, the result is not meaningful for typical financial analysis. A negative ratio does not provide a useful measure of leverage in the same way a positive ratio does. The key takeaway is the company's insolvency.

Question 2

Over the past fiscal year, a company's debt-to-equity ratio increased from 0.8 to 1.5, while its times interest earned ratio decreased from 7.0 to 3.0. Which of the following events is the most likely single cause of these changes?

  1. The company issued a large amount of common stock to fund research and development.
  2. A significant increase in sales and operating margin improved overall profitability.
  3. The company acquired a major competitor by issuing a large amount of long-term debt. (correct answer)
  4. The company paid down a substantial portion of its bonds payable using cash from operations.
Explanation: An increase in the debt-to-equity ratio means debt increased relative to equity. A decrease in the times interest earned ratio means EBIT decreased relative to interest expense. Acquiring a competitor by issuing debt would directly increase total debt, which increases the D/E ratio. It would also increase interest expense. Unless the acquired company immediately generated enough EBIT to offset the new interest expense, the TIE ratio would decrease. The other options are inconsistent with the observed changes.

Question 3

A company's balance sheet shows total assets of $1,200,000, common stock of $300,000, and retained earnings of $200,000. The company has no other equity accounts. What is the company's debt-to-equity ratio?

  1. 1.40 (correct answer)
  2. 2.40
  3. 0.71
  4. 0.58
Explanation: First, calculate total equity: Total Equity = Common Stock + Retained Earnings = $300,000 + $200,000 = $500,000. Second, calculate total liabilities using the accounting equation (Assets = Liabilities + Equity): Total Liabilities = Total Assets - Total Equity = $1,200,000 - $500,000 = $700,000. Finally, calculate the debt-to-equity ratio: Debt-to-Equity = Total Liabilities / Total Equity = $700,000 / $500,000 = 1.40.

Question 4

A company has a times interest earned ratio of 4.0 and interest expense of $150,000. During the year, the company incurred income tax expense of $180,000. What was the company's net income for the period?

  1. $270,000 (correct answer)
  2. $420,000
  3. $450,000
  4. $600,000
Explanation: This requires working backward through the income statement. First, calculate EBIT using the TIE ratio: TIE = EBIT / Interest Expense => 4.0 = EBIT / $150,000 => EBIT = $600,000. Second, calculate Earnings Before Tax (EBT): EBT = EBIT - Interest Expense = $600,000 - $150,000 = $450,000. Finally, calculate Net Income: Net Income = EBT - Taxes = $450,000 - $180,000 = $270,000.

Question 5

Apex Corporation reported the following for the current year: EBIT $450,000, Interest Expense $75,000, Income Tax Expense $93,750, and Preferred Dividends $30,000. If the company's times interest earned ratio needs to be at least 4.0 to maintain its current credit rating, what is the maximum additional annual interest expense the company can incur while maintaining this minimum ratio?

  1. $37,500, representing the difference between current coverage capacity and the minimum requirement (correct answer)
  2. $112,500, which would bring total interest expense to the maximum allowable under the constraint
  3. $75,000, effectively doubling the current interest expense while maintaining the minimum ratio
  4. $30,000, calculated as the amount that would reduce the ratio to exactly the minimum threshold
Explanation: Current TIE = $450,000 ÷ $75,000 = 6.0. For minimum TIE of 4.0: $450,000 ÷ (Total Interest) = 4.0, so Total Interest = $112,500. Additional interest = $112,500 - $75,000 = $37,500. Choice B gives total allowable interest, not additional. Choice C would result in TIE of 3.0. Choice D is arbitrary and doesn't relate to the calculation.

Question 6

A company's operating income (EBIT) is projected to decrease by 15% next year, while its interest expense is expected to remain constant. If the current times interest earned (TIE) ratio is 8.0, what will the projected TIE ratio be for next year?

  1. 6.80 (correct answer)
  2. 7.85
  3. 1.20
  4. 9.20
Explanation: Let the current EBIT be E and current Interest Expense be I. The current TIE ratio is E / I = 8.0. The projected EBIT for next year will be E * (1 - 0.15) = 0.85E. The interest expense remains I. The projected TIE ratio will be (0.85E) / I. We can rewrite this as 0.85 * (E / I). Since E / I = 8.0, the projected TIE is 0.85 * 8.0 = 6.80.

Question 7

A firm adopts new accounting standard ASC 842 and capitalizes a long-term operating lease. This requires the firm to recognize a 'right-of-use' asset and a corresponding lease liability on its balance sheet, where previously no asset or liability was recorded for this lease. Assume the firm had positive equity prior to this change.

What is the direct impact of capitalizing this operating lease on the firm's debt-to-equity ratio?

  1. It decreases, because a new asset is added to the balance sheet.
  2. It remains unchanged, as total assets increase by the same amount as total liabilities.
  3. It increases, because total liabilities increase while total equity remains unchanged. (correct answer)
  4. The impact cannot be determined because the lease payments are not specified.
Explanation: The debt-to-equity ratio is calculated as Total Liabilities / Total Equity. Capitalizing the lease increases total liabilities by adding a lease liability. The corresponding entry is an increase in assets (the right-of-use asset). There is no direct impact on total equity from this initial recognition. Therefore, the numerator (Total Liabilities) increases while the denominator (Total Equity) remains unchanged, causing the ratio to increase.

Question 8

An income statement shows the following: Operating Income $600,000; Interest Expense $120,000; Tax Expense $144,000; and Dividends on Preferred Stock $50,000.

Using the information provided, what is the times interest earned (TIE) ratio?

  1. 2.9
  2. 3.5
  3. 5.0 (correct answer)
  4. 2.5
Explanation: The times interest earned ratio is calculated as Earnings Before Interest and Taxes (EBIT) / Interest Expense. Operating Income is generally equivalent to EBIT. Therefore, TIE = Operating Income / Interest Expense = $600,000 / $120,000 = 5.0. Preferred stock dividends are paid out of net income (after taxes) and are not included in the standard TIE calculation. Including them would be a step toward calculating a fixed charge coverage ratio, not the TIE ratio.

Question 9

A company with a debt-to-equity ratio greater than zero issues new shares of common stock for cash. Assuming the transaction is executed at a price above book value, what is the immediate effect on the company's debt-to-equity ratio?

  1. It increases, because cash increases total assets.
  2. It decreases, because total equity increases while debt remains unchanged. (correct answer)
  3. It remains unchanged, because the transaction is a financing activity.
  4. It cannot be determined without knowing the amount of debt.
Explanation: The debt-to-equity ratio is Total Liabilities / Total Equity. When a company issues new shares for cash, its cash (an asset) increases and its common stock/APIC (equity) increases by the same amount. The numerator (Total Liabilities) is unchanged, while the denominator (Total Equity) increases. An increase in the denominator of a fraction results in a decrease in the value of the fraction. Therefore, the debt-to-equity ratio decreases.

Question 10

A company with positive retained earnings uses cash on hand to repurchase a significant number of its own shares, which it holds as treasury stock. What is the immediate effect of this transaction on the company's debt-to-equity ratio?

  1. It decreases, because the number of shares outstanding is reduced.
  2. It remains unchanged, because a company cannot have an ownership stake in itself.
  3. It increases, because cash and stockholders' equity both decrease. (correct answer)
  4. The effect cannot be determined without the market price of the stock.
Explanation: The debt-to-equity ratio is Total Liabilities / Total Equity. When a company buys back its own stock, it reduces cash (assets) and increases treasury stock (a contra-equity account). The increase in treasury stock reduces total stockholders' equity. The numerator, Total Liabilities, is unchanged. The denominator, Total Equity, decreases. A decrease in the denominator results in an increase in the ratio. Therefore, the debt-to-equity ratio increases.

Question 11

A company refinances $10 million of its 8% bonds payable with new 5% bonds payable of the same principal amount. Assuming the company's operating income remains constant, what is the most likely effect of this transaction on its times interest earned (TIE) ratio?

  1. It will increase because interest expense decreases. (correct answer)
  2. It will decrease because total debt has increased.
  3. It will remain the same because operating income is unchanged.
  4. It will remain the same because total liabilities are unchanged.
Explanation: The TIE ratio is calculated as EBIT / Interest Expense. By refinancing debt at a lower interest rate (from 8% to 5%), the company's annual interest expense decreases. Since the numerator (EBIT) is assumed to be constant and the denominator (Interest Expense) decreases, the TIE ratio will increase, indicating an improved ability to cover interest payments.

Question 12

A company arranges with its bank to reclassify $10 million of debt due in six months to a new loan due in five years. The total principal amount of debt and the effective interest rate remain the same. What is the effect of this refinancing on the company's debt-to-equity and times interest earned ratios?

  1. Debt-to-equity decreases; times interest earned is unchanged.
  2. Debt-to-equity is unchanged; times interest earned is unchanged. (correct answer)
  3. Debt-to-equity is unchanged; times interest earned increases.
  4. Both ratios will decrease.
Explanation: The debt-to-equity ratio is calculated using total liabilities. Reclassifying debt from short-term to long-term changes the composition of liabilities but not the total amount. Therefore, the debt-to-equity ratio is unchanged. The times interest earned ratio is EBIT / Interest Expense. The problem states that the interest rate remains the same, so interest expense is unchanged. As a result, the times interest earned ratio is also unchanged. While this transaction improves liquidity ratios (like the current ratio), it does not affect these specific leverage ratios.

Question 13

In calculating the times interest earned ratio to assess a company's ability to meet its debt obligations from its normal, recurring business activities, how should a large, one-time gain from the sale of a factory be treated?

  1. It should be included in the numerator because it is part of income before taxes.
  2. It should be excluded from the numerator because it is a non-operating and non-recurring item. (correct answer)
  3. It should be added to interest expense in the denominator to reflect the increased cash flow.
  4. It should be subtracted from interest expense because the cash can be used to pay interest.
Explanation: The purpose of the times interest earned ratio is to measure a company's ability to make interest payments using earnings from its ongoing operations. Therefore, the numerator should be a measure of recurring operating income (EBIT). A large, one-time gain from selling a factory is not part of normal operations and is unlikely to recur. Including it would distort the ratio and overstate the company's sustainable ability to cover interest payments. For analytical purposes, it should be excluded from EBIT.

Question 14

A company has total assets of $2,500,000 and total liabilities of $1,500,000. The company then recognizes a $200,000 impairment loss on its goodwill. What is the company's debt-to-equity ratio after the impairment loss is recorded?

  1. 1.88 (correct answer)
  2. 1.50
  3. 1.67
  4. 1.25
Explanation: First, determine the initial stockholders' equity: Equity = Assets - Liabilities = $2,500,000 - $1,500,000 = $1,000,000. An impairment loss on goodwill is an expense that reduces net income, which in turn reduces retained earnings and total equity. The new equity is $1,000,000 - $200,000 = $800,000. The impairment does not affect total liabilities. The new debt-to-equity ratio is Total Liabilities / New Equity = $1,500,000 / $800,000 = 1.875, or 1.88.

Question 15

Below are selected financial data for Bramble Corp.:

  • Accounts Payable: $150,000
  • Bonds Payable (due in 10 years): $500,000
  • Common Stock: $200,000
  • Retained Earnings: $450,000
  • Total Assets: $1,300,000

Based on the provided data, what is Bramble Corp.'s debt-to-equity ratio?

  1. 0.77
  2. 1.00 (correct answer)
  3. 0.50
  4. 2.00
Explanation: First, calculate total liabilities (debt). This includes all forms of debt, both current and long-term. Total Liabilities = Accounts Payable + Bonds Payable = $150,000 + $500,000 = $650,000. Second, calculate total equity. Total Equity = Common Stock + Retained Earnings = $200,000 + $450,000 = 650,000.TheTotalAssetsfigureconfirmsthebalancesheetequation(650,000. The Total Assets figure confirms the balance sheet equation (650,000 Liabilities + $650,000 Equity = $1,300,000 Assets). Finally, calculate the ratio: Debt-to-Equity = Total Liabilities / Total Equity = $650,000 / $650,000 = 1.00.

Question 16

The following information was extracted from Paxton Industries' balance sheet:

  • Current liabilities: $250,000
  • Bonds payable: $600,000
  • Preferred stock, cumulative: $100,000
  • Common stock, $1 par: $50,000
  • Additional paid-in capital—common: $450,000
  • Retained earnings: $300,000
  • Treasury stock (at cost): $25,000

Based on the information from Paxton Industries' balance sheet, what is the company's debt-to-equity ratio?

  1. 0.97
  2. 0.85
  3. 1.00
  4. 0.92 (correct answer)
Explanation: First, calculate total liabilities (debt): Total Liabilities = Current Liabilities + Bonds Payable = $250,000 + $600,000 = $850,000. Second, calculate total stockholders' equity: Equity = Preferred Stock + Common Stock + APIC + Retained Earnings - Treasury Stock = $100,000 + $50,000 + $450,000 + $300,000 - $25,000 = $925,000. Finally, calculate the debt-to-equity ratio: D/E = Total Liabilities / Total Equity = $850,000 / $925,000 ≈ 0.92.

Question 17

Phoenix Manufacturing has experienced significant changes in its capital structure over the past three years. The company's financial statements show the following year-end data for 2023: Long-term Debt $1,800,000, Short-term Debt $450,000, Common Stock $600,000, Retained Earnings $1,350,000, and Additional Paid-in Capital $300,000. The company paid $135,000 in interest during 2023 and reported EBIT of $540,000.

Based on the financial data provided, what conclusions can be drawn about Phoenix Manufacturing's leverage position and interest coverage capability?

  1. Debt-to-equity ratio of 1.5 with times interest earned of 5.0, showing aggressive leverage but excellent coverage
  2. Debt-to-equity ratio of 1.2 with times interest earned of 4.5, suggesting moderate leverage with strong coverage
  3. Debt-to-equity ratio of 0.9 with times interest earned of 3.5, indicating conservative leverage with marginal coverage
  4. Debt-to-equity ratio of 1.0 with times interest earned of 4.0, indicating balanced leverage and adequate coverage (correct answer)
Explanation: This question tests your ability to calculate and interpret two critical leverage ratios: debt-to-equity ratio and times interest earned. When analyzing a company's capital structure, these ratios reveal both the extent of financial leverage and the company's ability to service its debt obligations. To find the debt-to-equity ratio, you need total debt divided by total equity. Total debt includes both long-term debt (1,800,000)andshort−termdebt(1,800,000) and short-term debt (450,000), giving you 2,250,000.Totalequityconsistsofcommonstock(2,250,000. Total equity consists of common stock (600,000), retained earnings (1,350,000),andadditionalpaid−incapital(1,350,000), and additional paid-in capital (300,000), totaling $2,250,000. Therefore: $2,250,0002,250,000=1.0\frac{2,250,000}{2,250,000} = 1.0 $ For times interest earned, divide EBIT by interest expense: \frac{540,000}{135,000} = 4.0 Answer A incorrectly calculates a 1.5 debt-to-equity ratio, likely by excluding short-term debt or miscalculating equity components. The 5.0 times interest earned also suggests computational errors in the EBIT or interest figures. Answer B shows a 1.2 ratio, possibly from incorrectly categorizing some equity as debt, while the 4.5 coverage ratio indicates similar calculation mistakes. Answer C's 0.9 ratio might result from double-counting equity components or excluding legitimate debt, and the 3.5 coverage suggests errors in identifying the correct EBIT figure. Remember to always include all debt (short-term and long-term) when calculating leverage ratios, and ensure you're capturing all equity components from the balance sheet. These ratios are fundamental tools for assessing financial risk.

Question 18

Zenith Corporation's financial statements show the following information: Total Stockholders' Equity $3,600,000, Long-term Debt $2,160,000, Current Liabilities $1,440,000, EBITDA $756,000, Depreciation $126,000, and Interest Expense $194,400. The company is considering whether its current leverage ratios meet the covenant requirements of debt-to-equity not exceeding 1.0 and times interest earned not falling below 3.25. What is Zenith's compliance status?

  1. Compliant with both covenants, with debt-to-equity of 0.60 and times interest earned of 3.24, meeting requirements
  2. Non-compliant with debt-to-equity at 1.00 but compliant with times interest earned at 3.24, violating one covenant
  3. Non-compliant with both covenants, with debt-to-equity of 1.00 and times interest earned of 3.24, violating requirements (correct answer)
  4. Compliant with debt-to-equity at 0.60 but non-compliant with times interest earned at 3.24, violating one covenant
Explanation: Total debt = Long-term Debt $2,160,000 + Current Liabilities $1,440,000 = $3,600,000. Debt-to-equity = $3,600,000 ÷ $3,600,000 = 1.00 (violates ≤1.0 requirement). EBIT = EBITDA - Depreciation = $756,000 - $126,000 = $630,000. TIE = $630,000 ÷ $194,400 = 3.24 (violates ≥3.25 requirement). Both covenants are violated. Other choices incorrectly assess compliance status.

Question 19

Vista Enterprises reports the following year-end balances: Bonds Payable $2,800,000, Notes Payable $700,000, Accounts Payable $450,000, Accrued Liabilities $150,000, Common Stock $1,000,000, Additional Paid-in Capital $800,000, and Retained Earnings $1,400,000. If the company's policy is to exclude non-interest-bearing liabilities from leverage calculations, what is Vista's debt-to-equity ratio?

  1. 1.31, calculated using total liabilities in the numerator and total equity in the denominator
  2. 1.09, calculated using only interest-bearing debt in the numerator and total equity in the denominator (correct answer)
  3. 0.78, calculated using only long-term debt in the numerator and total equity in the denominator
  4. 1.94, calculated using total liabilities in the numerator and only contributed capital in the denominator
Explanation: When analyzing leverage ratios, you need to pay close attention to what types of liabilities the company includes in its calculations. Different companies may use different policies, and the question will specify these parameters. Vista's policy excludes non-interest-bearing liabilities from leverage calculations, so you only include debt that carries interest expense. From the given balances, the interest-bearing debt consists of Bonds Payable (2,800,000)andNotesPayable(2,800,000) and Notes Payable (700,000), totaling 3,500,000.ThetotalequityincludesCommonStock(3,500,000. The total equity includes Common Stock (1,000,000), Additional Paid-in Capital (800,000),andRetainedEarnings(800,000), and Retained Earnings (1,400,000), totaling $3,200,000. The debt-to-equity ratio is: $\frac{\3,500,000}{$3,200,000} = 1.09 Answer B correctly identifies this calculation using only interest-bearing debt in the numerator and total equity in the denominator. Answer A incorrectly includes all liabilities (4,100,000total),addingAccountsPayableandAccruedLiabilities,whicharenon−interest−bearingandshouldbeexcludedpercompanypolicy.AnswerCusesonlylong−termdebt(4,100,000 total), adding Accounts Payable and Accrued Liabilities, which are non-interest-bearing and should be excluded per company policy. Answer C uses only long-term debt (2,800,000) in the numerator, ignoring the Notes Payable which also bears interest. Answer D makes two errors: using total liabilities instead of just interest-bearing debt, and using only contributed capital ($1,800,000) instead of total equity in the denominator. Always read the company's specific policy on leverage calculations carefully. Many firms exclude operating liabilities like accounts payable since these don't represent borrowed capital with interest costs.

Question 20

Meridian Industries is analyzing its capital structure for potential loan approval. The company's current financial data shows: Total Assets $2,400,000, Total Liabilities $1,440,000, Annual Interest Expense $86,400, and Net Income $324,000. The company's tax rate is 25%, and management is considering issuing additional debt of $300,000 at 8% annual interest to fund expansion.

If Meridian Industries proceeds with the additional debt issuance, what will be the company's new debt-to-equity ratio, and how will this compare to the industry benchmark of 1.2?

  1. 1.81, which is significantly above the industry benchmark and may indicate excessive leverage risk (correct answer)
  2. 1.35, which is moderately above the industry benchmark and suggests acceptable leverage levels
  3. 1.50, which is above the industry benchmark but within reasonable risk parameters for expansion
  4. 2.71, which is substantially above the industry benchmark and indicates dangerous leverage levels
Explanation: Current equity = $2,400,000 - $1,440,000 = $960,000. New total debt = $1,440,000 + $300,000 = $1,740,000. New debt-to-equity ratio = $1,740,000 ÷ $960,000 = 1.81. This is significantly above the 1.2 benchmark. Choice B incorrectly calculates the ratio. Choice C uses wrong figures. Choice D incorrectly includes assets in the calculation.