Financial Ratios
Financial ratios are used to evaluate a company's liquidity, leverage, and financial health. Ratios are most useful when compared to industry peers or the company's own historical ratios.
The exam covers three financial ratios: Current Ratio, Quick Ratio, and Debt-to-Equity Ratio.
Liquidity Ratios (Can the company pay its bills?)
| 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
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 (potential liquidity problem)
Current Ratio 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
Quick Ratio (Acid-Test Ratio)
- A more conservative (stringent) measure of liquidity than the current ratio
- Excludes inventory because inventory may not be quickly convertible to cash
- Quick ratio is always equal to or less than the current ratio
Quick 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.
Leverage Ratios (How much debt is the company using?)
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 vs. equity
- Higher ratio = more leverage = more financial risk (more reliance on borrowed funds)
- Lower ratio = less leverage = less financial risk (more reliance on equity financing)
- A ratio of 1.0 means debt and equity are equal
- A ratio above 1.0 means the company has 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) - higher is generally better. Leverage ratios (debt-to-equity) - higher means more risk, not better. The exam may present a scenario where a company has a high current ratio but also high debt-to-equity, testing whether you understand one measures liquidity and the other measures leverage.