ACCA Advanced Financial Management (AFM) Practice Exam

Increasing debt affects which ratio significantly within a company’s financial statements?

1. Current ratio

2. Return on equity ratio

3. Debt-to-equity ratio

4. Gross profit margin

The correct answer is: Debt-to-equity ratio

Increasing debt has a significant impact on the debt-to-equity ratio, which measures the relative proportion of a company’s debt to its shareholders' equity. This ratio is crucial for investors as it indicates the financial leverage of a company; a higher ratio suggests that the company is relying more on borrowed funds to finance its operations relative to equity financing. When a company acquires more debt, its total liabilities increase, which consequently raises the debt-to-equity ratio. This change reflects a higher level of financial risk, as creditors may view the company as more leveraged and potentially more susceptible to financial distress. Conversely, if a company were to decrease its debt, the ratio would lower, indicating a healthier, less risky capital structure in relation to equity. In contrast, while the current ratio measures a company's ability to meet short-term obligations and could be affected indirectly by changes in debt if those debts are current liabilities, it is not the most direct measure impacted by increasing debt. Similarly, the return on equity ratio focuses on profitability as a function of shareholders' equity, and while an increase in debt may affect profitability, it does not directly alter this ratio in the same pronounced way. The gross profit margin, which gauges the efficiency of production as a percentage of sales, remains