What are the must-know financial ratios for CFA Level I and how do I interpret them?
There are so many ratios in the FRA section. I need a clear framework for organizing them into categories and knowing what each one actually tells an analyst. Which ones are most likely to show up on the exam?
Financial ratios are grouped into four main categories. Here is a concise reference with the formulas and what each ratio reveals.
1. Liquidity Ratios (Can the company pay short-term obligations?)
| Ratio | Formula | Interpretation |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | > 1.0 means more current assets than liabilities |
| Quick Ratio | (Cash + Receivables + Short-term Investments) / CL | Strips out inventory -- stricter test |
| Cash Ratio | (Cash + Short-term Investments) / CL | Most conservative liquidity measure |
2. Solvency Ratios (Can the company meet long-term obligations?)
| Ratio | Formula | Interpretation |
|---|---|---|
| Debt-to-Equity | Total Debt / Total Equity | Higher = more leveraged |
| Interest Coverage | EBIT / Interest Expense | How many times earnings cover interest |
| Debt-to-Assets | Total Debt / Total Assets | Proportion of assets funded by debt |
3. Profitability Ratios (How effectively does it generate profit?)
| Ratio | Formula | Interpretation |
|---|---|---|
| Gross Margin | Gross Profit / Revenue | Efficiency after direct costs |
| Operating Margin | Operating Income / Revenue | Efficiency after operating costs |
| Net Margin | Net Income / Revenue | Bottom-line profitability |
| ROE | Net Income / Average Equity | Return to shareholders |
| ROA | Net Income / Average Assets | Efficiency using all assets |
4. Activity Ratios (How efficiently does it use its assets?)
| Ratio | Formula | Interpretation |
|---|---|---|
| Inventory Turnover | COGS / Average Inventory | Times inventory is sold per year |
| Days Inventory | 365 / Inventory Turnover | Days to sell inventory |
| Receivables Turnover | Revenue / Average Receivables | Speed of collection |
| DSO | 365 / Receivables Turnover | Days to collect |
| Payables Turnover | COGS / Average Payables | Speed of payment |
DuPont Analysis decomposes ROE into three drivers:
ROE = Net Margin x Asset Turnover x Financial Leverage
Example: If Northstar Industries has ROE of 18%, you can decompose: 6% net margin x 1.5 asset turnover x 2.0 leverage = 18%. This tells you Northstar's ROE is driven equally by margins and leverage, not asset efficiency.
Exam Tip: Be prepared to calculate and interpret ratios from raw financial statements -- the exam rarely just asks for formulas.
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