Which financial ratio is typically kept low to signal financial leverage risk?

• A. Total liabilities / net worth
• B. Gross margin
• C. Current ratio
• D. Acid test

Answer: (A)

Leverage risk comes from how much debt a company uses compared with the funds provided by its owners. The ratio that directly shows this is total liabilities relative to net worth (debt-to-equity). It tells you how many dollars of debt exist for every dollar of equity. A higher value means more financial leverage, which amplifies both potential gains and potential losses and makes cash flows more vulnerable to downturns or rising interest costs. Because of that, this ratio is typically kept low to minimize leverage risk; when it rises, it signals greater financial risk to lenders and investors.

The other ratios measure profitability or liquidity rather than long-term leverage. Gross margin reflects profitability after production costs, not how much debt a company carries. The current ratio and the acid test assess short-term liquidity—whether the company can cover current obligations—rather than the level of debt relative to equity.