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

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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

$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

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

Interpretation:

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

Quick Ratio (Acid-Test Ratio)

$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$

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:

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

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Leverage (Solvency) Ratios

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

Debt-to-Equity Ratio

$\text{Debt-to-Equity} = \frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}$

Measures how much debt vs. equity finances the company.

Interpretation:

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

Debt Ratio

$\text{Debt Ratio} = \frac{\text{Total Liabilities}}{\text{Total Assets}}$

Measures the percentage of assets financed by debt.

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

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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

$\text{P/E Ratio} = \frac{\text{Stock Price}}{\text{Earnings Per Share (EPS)}}$

Measures how much investors pay per dollar of earnings.

Interpretation:

Two Types:

• Trailing P/E — Uses past 12 months earnings
• Forward P/E — Uses projected future earnings

PEG Ratio (Price/Earnings-to-Growth)

$\text{PEG Ratio} = \frac{\text{P/E Ratio}}{\text{Expected EPS Growth Rate}}$

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.

Price-to-Book (P/B) Ratio

$\text{P/B Ratio} = \frac{\text{Stock Price}}{\text{Book Value Per Share}}$

Measures price relative to accounting value.

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

Interpretation:

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Profitability Ratios

Return on Equity (ROE)

$\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}}$

Measures return generated on shareholders' investment.

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

Profit Margin

$\text{Profit Margin} = \frac{\text{Net Income}}{\text{Revenue}}$

Measures the percentage of revenue that becomes profit.

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

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Comparing Liquidity Ratios

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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

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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

Expect 2-3 questions on financial ratios. Common formats include calculating a ratio from given data or interpreting what a ratio indicates.

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Key Takeaways

• Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}}$ (includes inventory)
• Quick Ratio: $\frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$ (excludes inventory)
• Debt-to-Equity: $\frac{\text{Total Liabilities}}{\text{Shareholders' Equity}}$
• 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 (< 1.0 may indicate undervaluation)
• Compare ratios to industry peers and historical trends
• No single ratio tells the complete story—use multiple ratios together