Quick Answer
Financial ratios turn balance sheet and income statement figures into comparable measures of liquidity, solvency, efficiency, profitability, and valuation. The exam tests the exact formula for each ratio and what a high or low result implies about a company's short-term safety, leverage, and share price.
Now that you understand the balance sheet and income statement, financial ratios let you extract meaningful insights from those numbers. Ratios are the primary toolkit for fundamental analysis.
What Are the Liquidity Ratios?
Liquidity ratios measure a company's ability to meet short-term obligations: can it pay its bills?
| Ratio | Formula | Interpretation |
|---|---|---|
| Working capital | Current assets - Current liabilities | Dollar amount of short-term cushion; must be positive for healthy liquidity |
| Current ratio | Current assets / Current liabilities | Ability to pay short-term obligations; higher is better; >1.0 = positive working capital |
| Quick ratio (Acid test) | (Current assets - Inventory) / Current liabilities | More conservative than current ratio; excludes inventory |
- Quick assets = Cash + Marketable securities + Accounts receivable (current assets minus inventory)
- The acid test is more stringent because inventory is the least liquid current asset (it may not be easily converted to cash)
Exam Tip: Gotchas
- The quick ratio removes inventory from current assets because inventory is the least liquid current asset. If a company has a high current ratio but a low quick ratio, it is heavily dependent on inventory for its liquidity.
- Current ratio includes ALL current assets; quick ratio excludes inventory. The exam frequently tests this distinction.
What Are the Solvency/Leverage Ratios?
Solvency ratios measure long-term financial risk: how much debt does the company carry?
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt-to-equity ratio | Total debt / Total shareholders' equity | Measures financial leverage; higher = more leveraged = higher bankruptcy risk |
| Bond ratio | Total bonds outstanding / Total capitalization | Proportion of capital structure funded by debt |
- Total capitalization = Long-term debt + Preferred stock + Common equity (shareholders' equity)
- A rising debt-to-equity ratio signals increasing reliance on borrowed funds
- Bond investors focus heavily on leverage ratios to assess credit risk
Exam Tip: Gotchas
- Total capitalization includes long-term debt, preferred stock, AND common equity. A common mistake is forgetting preferred stock when calculating total capitalization.
- A rising debt-to-equity ratio is a warning sign for bondholders, not just equity investors. More debt means higher bankruptcy risk and potentially lower bond ratings.
What Are the Efficiency Ratios?
Efficiency ratios measure how effectively a company uses its assets.
| Ratio | Formula | Interpretation |
|---|---|---|
| Inventory turnover | Cost of goods sold (COGS) / Average inventory | How quickly inventory is sold; higher = more efficient |
| Cash flow | Net income + Depreciation + Depletion + Amortization | Approximation of actual cash generated (adds back non-cash charges) |
- High inventory turnover means the company is moving product quickly
- Cash flow adds back non-cash expenses to approximate true cash generation
What Are the Profitability Ratios?
Profitability ratios measure how well a company converts revenue and assets into profit.
| Ratio | Formula | Interpretation |
|---|---|---|
| Gross profit margin | Gross profit / Revenue | Percentage of revenue remaining after COGS |
| Net profit margin (net profit ratio / margin of profit) | Net income / Revenue | Percentage of revenue that becomes profit after ALL expenses |
| Return on equity (ROE) / Return on common equity | Net income / Shareholders' equity | How efficiently the company generates profit from shareholders' investment |
| Asset coverage | (Total assets - Intangible assets) / Total debt outstanding | Safety measure for bondholders; tangible assets available to cover debt |
| Net asset value (NAV) per bond | (Total assets - Intangible assets - Current liabilities) / Number of bonds outstanding | Net tangible asset backing per bond |
| Bond interest coverage | Earnings before interest and taxes (EBIT) / Annual interest expense | Times interest earned; how many times earnings can cover interest payments |
| Book value per share | (Total assets - Liabilities - Intangible assets - Preferred stock) / Common shares outstanding | Tangible book value per common share |
- ROE, also called return on common equity, is the outline's key competitiveness (comparative performance) measure: it shows how much profit each dollar of equity generates. When the company has preferred stock outstanding, ROE generally subtracts preferred dividends from net income and uses common equity in the denominator, the same adjustment applied to EPS
- Asset coverage, NAV per bond, and bond interest coverage together make up what the exam calls "asset coverage and safety of income": the group of ratios bondholders use to judge how safely a company's earnings and assets can cover its debt
- Bond interest coverage (times interest earned) tells bondholders how safe their interest payments are; higher is better
- Book value per share represents the accounting value of each share if the company were liquidated
Exam Tip: Gotchas
- Book value per share excludes intangible assets (goodwill, patents) AND preferred stock. The exam may include these in the assets figure to test whether you know to subtract them. Tangible assets only, common shareholders only.
- Bond interest coverage uses EBIT (earnings before interest and taxes), not net income. Using net income would undercount because interest has already been subtracted.
What Are the Valuation Ratios?
Valuation ratios compare a stock's market price to its fundamental measures.
| Ratio | Formula | Interpretation |
|---|---|---|
| Price-to-earnings (P/E) ratio | Market price per share / Earnings per share (EPS) | How much investors pay per dollar of earnings |
| Dividend payout ratio | Annual dividends per share / EPS | Percentage of earnings paid out as dividends |
| Current yield (stocks) | Annual dividend per share / Current market price | Income return on a stock at today's price |
Understanding P/E Ratios
- A high P/E ratio suggests the market expects strong future earnings growth (growth stock)
- A low P/E ratio may indicate the stock is undervalued or the market expects declining earnings (value stock)
- Use fully diluted EPS in P/E calculations for the most conservative measure
Exam Tip: Gotchas
- The P/E ratio uses MARKET PRICE (not book value) in the numerator. Do not confuse P/E ratio with book value per share. Also, a high P/E is not automatically "good"; it may mean the stock is overpriced relative to earnings.
- Dividend payout ratio + retention ratio = 100%. What is not paid out as dividends is retained by the company. If payout ratio is 40%, the retention ratio is 60%.
What Should You Check on Exam Day?
- Quick ratio (acid test) excludes inventory; current ratio includes it.
- Total capitalization = long-term debt + preferred stock + common equity. Forgetting preferred stock is the classic mistake.
- Bond interest coverage uses EBIT, not net income.
- Book value per share subtracts both intangible assets and preferred stock before dividing by common shares.
- P/E ratio uses market price, not book value, and should use fully diluted EPS for the most conservative figure.