Financial Ratios

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.

Which Liquidity Ratios Show Whether a Company Can Pay Its Bills?

Current Ratio: Formula: Current Assets divided by Current Liabilities. What it measures: Ability to meet short-term obligations.

Quick Ratio (Acid Test): Formula: (Current Assets minus Inventory) divided by Current Liabilities. What it measures: 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 equals 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 dollars.

Current liabilities: 200,000 dollars.

Current ratio: 500,000 dollars divided by 200,000 dollars equals 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 dollars.

Inventory: 150,000 dollars.

Current liabilities: 200,000 dollars.

Quick ratio: (500,000 dollars minus 150,000 dollars) divided by 200,000 dollars equals 350,000 dollars divided by 200,000 dollars equals 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.

Which Leverage Ratio Shows How Much Debt a Company Uses?

Debt-to-Equity (D/E) Ratio

Formula: D/E equals Total Liabilities divided by 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.

Some textbooks put only borrowed money (loans and bonds) on top instead of all liabilities. This course uses total liabilities. If a question gives you a debt figure and an equity figure, divide the debt figure by the equity figure.

Worked Example:

Total liabilities: 400,000 dollars.

Shareholders' equity: 200,000 dollars.

D/E ratio: 400,000 dollars divided by 200,000 dollars equals 2.0.

Interpretation: for every 1 dollar of equity, the company has 2 dollars of debt.

Direction matters: flipping the fraction (200,000 dollars divided by 400,000 dollars equals 0.5) gives equity-to-debt, a different ratio. The D/E ratio always has liabilities on top, so it reads as debt per 1 dollar of equity.

How Do the Financial Ratios Compare?

Current: Formula: Current Assets divided by Current Liabilities. Measures: Short-term liquidity. Higher equals more liquid.

Quick: Formula: (Current Assets minus Inventory) divided by Current Liabilities. Measures: Strict liquidity. Higher equals more liquid.

Debt-to-Equity: Formula: Total Liabilities divided by Shareholders' Equity. Measures: Financial leverage. Higher equals 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 equals 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.

Additional Details

Published: 2026-11-02T21:59:23.883Z