ACCA Financial Reporting (F7) Practice Exam

What does a high debt-to-equity ratio indicate about a company?

1. The company has a good balance between debt and equity

2. The company may be taking on excessive risk

3. The company has low operational efficiency

4. The company is likely to invest in long-term assets

The correct answer is: The company may be taking on excessive risk

A high debt-to-equity ratio signals that a company is primarily financing its operations through debt rather than equity. This situation can imply that the company is taking on excessive risk, as relying heavily on borrowed funds exposes it to higher financial obligations, such as interest payments and debt repayment. If the company's earnings do not meet expectations, it may struggle to meet these obligations, resulting in potential insolvency or financial distress. This level of leverage can also indicate that the company is in a phase of expansion or aggressive growth, which can be risky if not managed carefully. While using debt can enhance returns if investments are profitable, the reliance on a high amount of debt without sufficient equity can lead to increased vulnerability in adverse market conditions. In contrast to other potential interpretations, such as a balanced financing approach or that the company is investing wisely in long-term assets, a high debt-to-equity ratio predominantly serves as a red flag for stakeholders regarding financial risk and stability. Understanding this balance is crucial in assessing the company’s overall financial health and risk profile.