A financial analyst is evaluating the solvency and liquidity of Flagstaff Manufacturing and has collected the following data: $$\begin{array} { | l | r | r | r | }
\hline & \underline { \mathbf { 2 0 X 7 } } & \underline { \mathbf { 2 0 X 6 } } & \underline { \mathbf { 2 0 X 5 } } \
\hline \text { Total debt } & \$ 2,000 & \$ 1,900 & \$ 1,750 \
\hline \text { Total equity } & \$ 4,000 & \$ 4,500 & \$ 5,000 \
\hline
\end{array}$$ What would the analyst be most likely to conclude?
A) The company is becoming increasingly less solvent as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
B) The company is becoming increasingly less liquid as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
C) The company is becoming increasingly more solvent as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
D) The company is becoming increasingly more liquid as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.

Question

A financial analyst is evaluating the solvency and liquidity of Flagstaff Manufacturing and has collected the following data: $$\begin{array} { | l | r | r | r | } 
\hline & \underline { \mathbf { 2 0 X 7 } } & \underline { \mathbf { 2 0 X 6 } } & \underline { \mathbf { 2 0 X 5 } } \
\hline \text { Total debt } & \$ 2,000 & \$ 1,900 & \$ 1,750 \
\hline \text { Total equity } & \$ 4,000 & \$ 4,500 & \$ 5,000 \
\hline
\end{array}$$ What would the analyst be most likely to conclude?
A) The company is becoming increasingly less solvent as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
B) The company is becoming increasingly less liquid as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
C) The company is becoming increasingly more solvent as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.
D) The company is becoming increasingly more liquid as evidenced by the increase in its debt to equity ratio from 0.35 in 20X5 to 0.50 in 20X7.

Quizplus · Accepted Answer

The debt to equity ratio is a measure of solvency, not liquidity. An increase in this ratio, from 0.35 to 0.50, indicates the company is relying more on debt relative to equity, thus becoming less solvent.

A Financial Analyst Is Evaluating the Solvency and Liquidity of Flagstaff