Charta is on Google Play: practise on the go. Get the app
Charta

Work out liquidity, solvency and activity ratios and explain what they mean

CFA® Level I · Financial Statement Analysis · Financial Analysis Techniques · FSA.5.a

The idea

Ratios turn statements into comparisons. Liquidity ratios ask whether short-term obligations can be met — the current ratio, and the quick ratio which strips out inventory as the least certain current asset. Solvency ratios ask about the longer term, with debt-to-equity and interest coverage. Activity ratios ask how hard assets are working: inventory turnover, receivables turnover, and the days figures derived from them. No ratio means anything alone. It has to be read against the same firm's history, a peer, or an industry norm — and a rising current ratio is as easily a sign of unsold inventory as of improving health.

Formulas

Total asset turnover

total asset turnover = revenue ÷ average total assets

revenue
sales for the period
average total assets
opening and closing total assets averaged

Sales generated per unit of assets, and the middle term of the DuPont decomposition. It is only comparable within an industry: a retailer and a utility have no reason to be near each other.

Cash ratio

cash ratio = (cash + short-term investments) ÷ current liabilities

cash
cash and equivalents
short-term investments
marketable securities saleable at once
current liabilities
obligations due within a year

The strictest liquidity measure: it assumes neither receivables nor inventory can be turned into cash. That is the assumption worth making in a crisis, which is when the ratio is read.

A practice question

From the question bank, with the reason each wrong option is wrong.

The current ratio is current assets divided by:

  1. current liabilities — correct
  2. total liabilitiesWhy not: That mixes a short-term numerator with a long-term denominator. A company with a large bond maturing in nine years would look illiquid for no good reason.
  3. equityWhy not: Equity is a residual claim with no due date. The current ratio is about obligations that fall due soon.

Both sides of the ratio are short-term, which is what makes it a statement about near-term obligations.

A harder one

Current assets are $300 and current liabilities are $150. The current ratio is:

  1. 0.5Why not: 150 ÷ 300 — the ratio inverted. Current assets go on top, since the question is whether they cover the liabilities.
  2. 1.5Why not: Close to the figure a 240/150 balance would give. Here 300 ÷ 150 is exactly 2.0.
  3. 2.0 — correct

Three hundred divided by 150 is 2.0, meaning short-term assets cover short-term obligations twice over.

The hardest tier

A single ratio taken in isolation is of limited use mainly because it lacks:

  1. precisionWhy not: It is usually precise enough — computed from audited figures to several decimal places. Precision is not the missing ingredient.
  2. statistical significanceWhy not: A ratio is a descriptive figure about one company at one date, not an estimate from a sample, so significance does not apply.
  3. a benchmark — history, a peer, or an industry norm — correct

A current ratio of 1.4 is comfortable in one industry and alarming in another, and the number alone cannot say which.

In the app: 18 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Financial Analysis Techniques