The ratio total liabilities / net worth should be which?

• A. 1-2
• B. 2-3
• C. 3-4
• D. less than 1

Answer: (D)

The concept here is leverage and the relationship between debt and equity. Net worth represents the cushion available to cover obligations after all debts are paid. Since assets equal liabilities plus net worth, having more net worth than liabilities means a stronger, safer balance sheet. Therefore, the ratio of total liabilities to net worth should be less than 1, showing that the equity cushion exceeds the debt. A ratio of 1 or higher would indicate liabilities are as large as or larger than net worth, signaling higher leverage and more risk.