2.4 Financial Ratios

Financial ratios allow investment advisers to analyze and compare companies. By expressing financial data as ratios, advisers can evaluate liquidity, leverage, profitability, and valuation regardless of company size.

Why Ratios Matter

Ratios provide:

- Comparability - Compare companies of different sizes

- Trend Analysis - Track changes over time

- Benchmarking - Compare against industry standards

- Quick Assessment - Summarize complex financials

Liquidity Ratios

Liquidity ratios measure a company's ability to pay short-term obligations. They're particularly important for creditors and for assessing near-term financial health.

Current Ratio

Current Ratio = Current Assets / Current Liabilities

Measures ability to pay short-term debts with short-term assets.

Interpretation:

Greater than 1.0: Company has more current assets than current liabilities

Less than 1.0: Company may struggle to pay short-term obligations

2.0: Often considered healthy (depends on industry)

Example: $500,000 / $250,000 = 2.0

Quick Ratio (Acid-Test Ratio)

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Measures ability to pay short-term debts with liquid assets only.

Why Exclude Inventory?

- Inventory may not sell quickly

- Inventory value may decline

- More conservative measure than current ratio

Interpretation:

Greater than 1.0: Can pay current liabilities without selling inventory

Less than 1.0: May need to sell inventory or borrow to pay obligations

Example: ($500,000 - $150,000) / $250,000 = 1.4

Leverage (Solvency) Ratios

Leverage ratios measure long-term solvency and how much debt a company uses in its capital structure.

Debt-to-Equity Ratio

Debt-to-Equity = Total Liabilities / Shareholders' Equity

Measures how much debt vs. equity finances the company.

Interpretation:

Less than 1.0: More equity than debt financing

Greater than 1.0: More debt than equity financing

Greater than 2.0: Highly leveraged; higher financial risk

Industry Context: Capital-intensive industries (utilities, manufacturing) typically have higher D/E ratios than service industries.

Debt Ratio

Debt Ratio = Total Liabilities / Total Assets

Measures the percentage of assets financed by debt.

Example: $400,000 / $1,000,000 = 40% debt ratio

Valuation Ratios

Valuation ratios help determine whether a stock is overvalued or undervalued relative to its earnings, growth, or assets.

Price-to-Earnings (P/E) Ratio

P/E Ratio = Stock Price / Earnings Per Share (EPS)

Measures how much investors pay per dollar of earnings.

Interpretation:

Less than 15: May indicate undervalued or slower growth

15-25: Typical range for many stocks

Greater than 25: Premium valuation; high growth expected

Two Types:

- Trailing P/E - Uses past 12 months earnings

- Forward P/E - Uses projected future earnings

PEG Ratio (Price/Earnings-to-Growth)

PEG Ratio = P/E Ratio / Expected EPS Growth Rate

Measures P/E relative to growth rate.

Why It's Useful: Accounts for growth - a high P/E may be justified if growth is high.

Less than 1.0: Potentially undervalued relative to growth

Equal to 1.0: P/E justified by growth rate

Greater than 1.0: Potentially overvalued relative to growth

Price-to-Book (P/B) Ratio

P/B Ratio = Stock Price / Book Value Per Share

Measures price relative to accounting value.

Book Value = Total Assets - Total Liabilities (shareholders' equity)

Interpretation:

Less than 1.0: Stock trades below accounting value (potential value opportunity)

Equal to 1.0: Stock trades at book value

Greater than 1.0: Premium to book value (market expects future growth)

Profitability Ratios

Return on Equity (ROE)

ROE = Net Income / Shareholders' Equity

Measures return generated on shareholders' investment.

Example: $100,000 / $500,000 = 20% ROE

Profit Margin

Profit Margin = Net Income / Revenue

Measures the percentage of revenue that becomes profit.

Example: $50,000 / $500,000 = 10% profit margin

Comparing Liquidity Ratios

Current Ratio: Formula Current Assets / Current Liabilities. Includes Inventory? Yes. More Conservative? No

Quick Ratio: Formula (Current Assets - Inventory) / Current Liabilities. Includes Inventory? No. More Conservative? Yes

In Practice: How Investment Advisers Apply This

Analyzing a potential investment:

- Compare ratios to industry peers

- Look at trends over 3-5 years

- Consider the company's business model

- Don't rely on a single ratio - use multiple

Red Flags:

- Declining liquidity ratios

- Rapidly increasing debt-to-equity

- P/E much higher than peers without justification

- ROE declining over time

On the Exam

The Series 65 exam tests your ability to:

1. Calculate current ratio, quick ratio, and debt-to-equity

2. Interpret what ratios indicate about financial health

3. Distinguish between liquidity and leverage ratios

4. Understand valuation ratios (P/E, PEG, P/B)

5. Compare current ratio vs. quick ratio

Common formats include calculating a ratio from given data or interpreting what a ratio indicates.

Key Takeaways

- Current Ratio: Current Assets / Current Liabilities (includes inventory)

- Quick Ratio: (Current Assets - Inventory) / Current Liabilities (excludes inventory)

- Debt-to-Equity: Total Liabilities / Shareholders' Equity

- Quick ratio is more conservative than current ratio

- P/E ratio shows how much investors pay per dollar of earnings

- PEG ratio adjusts P/E for growth rate (less than 1.0 may indicate undervaluation)

- Compare ratios to industry peers and historical trends

- No single ratio tells the complete story - use multiple ratios together