Quick Answer
Financial ratios evaluate a company's liquidity, leverage, and financial health. The current and quick ratios test whether a company can pay short-term obligations; the debt-to-equity ratio tests how much of its financing comes from debt versus equity. Compare ratios to industry peers or the company's own history, not in isolation.
The exam covers three financial ratios: current ratio, quick ratio, and debt-to-equity ratio. Each answers a different underlying question about the company's financial position.
Can the Company Pay Its Bills? (Liquidity Ratios)
| Ratio | Formula | What It Measures |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Ability to meet short-term obligations |
| Quick Ratio (Acid Test) | (Current Assets - Inventory) / Current Liabilities | Stricter liquidity test |
Current assets include: cash, accounts receivable, inventory, marketable securities.
Current liabilities include: accounts payable, short-term debt, accrued expenses.
How Do You Read the Current Ratio?
- Higher ratio = more liquidity (better ability to meet short-term debts)
- A current ratio below 1.0 means current liabilities exceed current assets, a potential liquidity problem
Worked Example:
- Current assets: $500,000
- Current liabilities: $200,000
- Current ratio: $500,000 / $200,000 = 2.5
- Interpretation: the company can cover its short-term obligations 2.5 times over
How Does the Quick Ratio Differ?
- A more conservative (stringent) measure of liquidity than the current ratio
- Excludes inventory because inventory may not be quickly convertible to cash
- The quick ratio is always equal to or less than the current ratio
Worked Example:
- Current assets: $500,000
- Inventory: $150,000
- Current liabilities: $200,000
- Quick ratio: ($500,000 - $150,000) / $200,000 = $350,000 / $200,000 = 1.75
- Interpretation: the company can cover its short-term debts 1.75 times using only its most liquid assets
Exam Tip: Gotchas
The only difference between the current ratio and quick ratio is that the quick ratio removes inventory from the numerator. If a question asks which ratio is more conservative or stringent, the answer is the quick ratio. If inventory is zero, the two ratios are identical.
How Much Debt Is the Company Using? (Leverage Ratio)
Debt-to-Equity (D/E) Ratio
- Formula: D/E = Total Liabilities / Shareholders' Equity
- Measures the proportion of a company's financing that comes from debt versus equity
- Higher ratio means more leverage and more financial risk (more reliance on borrowed funds)
- Lower ratio means less leverage and less financial risk (more reliance on equity financing)
- A ratio of 1.0 means debt and equity are equal; above 1.0 means more debt than equity
Worked Example:
- Total liabilities: $400,000
- Shareholders' equity: $200,000
- D/E ratio: $400,000 / $200,000 = 2.0
- Interpretation: for every $1 of equity, the company has $2 of debt
Summary: Financial Ratios
| Ratio | Formula | Measures | Higher = |
|---|---|---|---|
| Current | Current Assets / Current Liabilities | Short-term liquidity | More liquid |
| Quick | (Current Assets - Inventory) / Current Liabilities | Strict liquidity | More liquid |
| Debt-to-Equity | Total Liabilities / Shareholders' Equity | Financial leverage | More risk |
Exam Tip: Gotchas
Liquidity ratios (current, quick) are better when higher. Leverage ratios (debt-to-equity) are riskier when higher, not better. Watch for a scenario testing a company with both a high current ratio and high debt-to-equity, checking whether you know one measures liquidity and the other measures leverage.
What Should You Check on Exam Day?
- Quick ratio = current ratio minus inventory in the numerator; it is always the lower (or equal) figure.
- A current ratio below 1.0 signals a potential liquidity problem.
- Debt-to-equity above 1.0 means the company carries more debt than equity.
- A high liquidity ratio and a high leverage ratio can coexist; they measure different things.