ExpertHard1 markMultiple Choice
CPA · Question 31 · Area II: Balance Sheet Accounts
Pacific Corp. has a debt covenant that requires maintaining a debt-to-equity ratio of no more than 2.0:1. At year-end, Pacific has:<br/>- Total debt: $1,800,000<br/>- Total stockholders' equity: $950,000<br/><br/>Is Pacific in compliance with its debt covenant?
Pacific Corp. has a debt covenant that requires maintaining a debt-to-equity ratio of no more than 2.0:1. At year-end, Pacific has:<br/>- Total debt: $1,800,000<br/>- Total stockholders' equity: $950,000<br/><br/>Is Pacific in compliance with its debt covenant?
Answer options:
A.
Yes, the debt-to-equity ratio is 1.89:1, which is below the 2.0:1 maximum
B.
No, the debt-to-equity ratio is 1.89:1, which exceeds the 2.0:1 maximum
C.
Yes, the debt-to-equity ratio is 0.53:1, which is below the 2.0:1 maximum
D.
No, the debt-to-equity ratio is 2.75:1, which exceeds the 2.0:1 maximum
How to approach this question
Calculate debt-to-equity ratio as total debt divided by total stockholders' equity. Compare the result to the covenant requirement to determine compliance.
Full Answer
A.Yes, the debt-to-equity ratio is 1.89:1, which is below the 2.0:1 maximum✓ Correct
No, the debt-to-equity ratio is 1.89:1, which exceeds the 2.0:1 maximum
Debt covenants are contractual agreements that require maintaining certain financial ratios. The debt-to-equity ratio measures financial leverage. Pacific's ratio = $1,800,000 ÷ $950,000 = 1.89:1. Since 1.89 < 2.0, Pacific is in compliance with the covenant requirement.
Common mistakes
Inverting the ratio (equity ÷ debt), misinterpreting whether the calculated ratio violates the covenant, or mathematical errors in the division
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