Ratios and analysis techniques - Profitability liquidity and...

Learning Outcomes

This article explains how to apply profitability, liquidity, and solvency ratios in CFA Level 1-style financial analysis, including:

• calculating core profitability ratios (gross, operating, and net profit margins, ROA, and ROE) from financial statements and identifying what each reveals about earnings quality and management efficiency;
• computing key liquidity ratios (current, quick, and cash ratios), interpreting results against benchmarks, and assessing a firm’s capacity to meet short-term obligations;
• deriving solvency ratios (debt-to-equity, debt ratio, and interest coverage), evaluating long-term financial risk, and distinguishing leverage-driven returns from sustainable performance;
• interpreting ratio movements over time, linking trends to changes in operations, capital structure, and working capital management, and spotting early warning signals of distress;
• comparing ratios across firms and industries, adjusting for business models and accounting choices, and recognizing when ratios are not directly comparable;
• integrating multiple ratios to form a coherent exam-style judgment on profitability, liquidity, and solvency, and avoiding common CFA Level 1 pitfalls such as confusing liquidity and solvency measures or over-relying on a single indicator;
• applying additional liquidity measures (such as the defensive interval ratio and cash conversion cycle) to evaluate how long a firm can operate using existing liquid assets and how quickly it converts investment in working capital back into cash.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are required to understand the calculation, interpretation, and uses of core ratios for financial statement analysis, with a focus on the following syllabus points:

• calculating profitability ratios and interpreting what they reveal about company performance;
• calculating liquidity ratios and assessing a firm’s short-term financial health;
• calculating solvency ratios and evaluating long-term financial stability and gearing;
• using ratio analysis to compare companies, identify trends, and make judgments about financial risks and returns;
• recognizing the limitations of ratio analysis and the importance of using ratios together with qualitative information.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which ratio most directly measures a company’s ability to meet its short-term obligations as they come due?
   1. Return on equity
   2. Current ratio
   3. Debt-to-equity ratio
   4. Net profit margin
2. A company reports a very high ROE but very low current and quick ratios. Which interpretation is most appropriate?
   1. The firm is highly profitable with no financial risk
   2. The firm is likely over-invested in long-term assets
   3. The firm uses significant leverage and faces liquidity risk
   4. The firm has excess cash and underutilized assets
3. A high debt-to-equity ratio usually implies that a firm:
   1. has low financial risk and strong liquidity
   2. relies heavily on equity financing and has low leverage
   3. has high financial leverage and greater long-term default risk
   4. is more efficient at generating sales from its assets

Introduction

Financial ratio analysis provides a structured approach for evaluating a company’s performance, financial health, and risk. By calculating and interpreting a range of key ratios, analysts can compare companies to each other and track results over time. This article covers the core profitability, liquidity, and solvency ratios, their calculation, and their interpretation for CFA exam purposes.

Ratios combine information from the income statement, balance sheet, and sometimes the cash flow statement. They standardize data so that:

• performance can be compared across firms of different sizes;
• trends can be identified across time for the same firm;
• analysts can link operating decisions (such as pricing or credit policy) to financial outcomes.

Key Term: ratio analysis
Ratio analysis is the process of using standard ratios to evaluate financial statement data, allowing comparison of a company’s performance, risk, and financial position across firms and periods.

Ratios are often grouped into categories:

• profitability ratios (margins, returns on assets and equity) focus on profit generation;
• liquidity ratios (current, quick, cash) focus on short-term obligations;
• solvency ratios (debt and coverage measures) focus on long-term financial risk and leverage;
• activity or efficiency ratios (turnover measures such as inventory days and receivables days) focus on how effectively assets are used.

This article concentrates on profitability, liquidity, and solvency, but you will see that activity ratios interact closely with liquidity and profitability. For example, slow inventory turnover (an activity ratio) usually worsens the cash conversion cycle (a liquidity measure) and can eventually squeeze profitability.

Key Term: profitability ratios
Profitability ratios measure a company’s ability to generate earnings relative to sales, assets, or equity.

Key Term: liquidity ratios
Liquidity ratios evaluate a company’s ability to meet short-term obligations using its most liquid assets.

Key Term: solvency ratios
Solvency ratios assess a company’s long-term financial health by measuring gearing (leverage) and its capacity to meet long-term liabilities.

Key Term: liquidity
Liquidity refers either to how quickly an asset can be converted to cash at low cost or, for a firm, to its ability to meet short-term obligations as they come due.

Ratio values do not provide answers by themselves; they must be interpreted in the context of:

• the firm’s business model and industry (for example, capital-intensive versus service businesses);
• accounting policies and estimates (such as inventory methods or depreciation);
• broader economic conditions (growth, interest rates, inflation).

Analysts also distinguish between two basic approaches when working with ratios:

• horizontal or trend analysis: comparing ratios over multiple periods for the same firm;
• cross-sectional analysis: comparing a firm’s ratios with peers or industry averages at a point in time.

Both are heavily tested at Level 1 and are almost always implied in exam mini-scenarios.

In addition, some ratios are based on period-end balance sheet figures, whereas income statement numbers cover an entire period. For ratios that mix income statement and balance sheet items (such as ROA), it is often better to use average balance sheet figures to represent the resources employed over the period.

Finally, ratio analysis is often combined with common-size financial statements (expressing each income statement line as a percentage of sales and each balance sheet item as a percentage of total assets). Common-size statements help you see composition changes (for example, inventory swelling as a percentage of assets) that explain movements in ratios.

The following sections examine profitability, liquidity, and solvency ratios in turn and then show how to combine them in exam-style analysis.

Profitability Ratios

Profitability ratios show how efficiently a company generates profits. These ratios are critical for comparing performance across companies and for assessing management effectiveness. The most tested and commonly used profitability ratios include:

• gross profit margin;
• operating profit margin;
• net profit margin;
• return on assets (ROA);
• return on equity (ROE).

At Level 1 you also need to be aware of a few additional profit-based ratios that build on these core ideas, such as EBITDA margin, operating return on assets, and return on total capital. These are introduced after the core measures.

Core margins and return ratios

• Gross Profit Margin: Gross Profit / Revenue. Indicates how much profit a company retains after cost of goods sold (COGS). Higher margins suggest stronger pricing power or cost control at the production or direct service-delivery level.

Key Term: gross profit margin
Gross profit margin is gross profit divided by revenue and reflects the profitability of a firm’s core products or services before operating expenses.

• Operating Profit Margin: Operating Profit / Revenue. Reflects profit before interest and taxes, measuring core business efficiency after operating expenses such as selling, general, administrative, and often research and development costs.

Key Term: operating profit margin
Operating profit margin is operating profit (often EBIT) divided by revenue; it captures how well a company controls operating costs relative to sales.

• Net Profit Margin: Net Income / Revenue. Represents overall profitability after all expenses, including interest and taxes. This is the broadest margin and is highly sensitive to financing and tax decisions.

Key Term: net profit margin
Net profit margin is net income divided by revenue and indicates how much of each currency unit of sales is converted into profit available to shareholders.

• Return on Assets (ROA): Net Income / Average Total Assets. Measures how effectively assets are used to generate profit.

Key Term: return on assets (ROA)
ROA is net income divided by average total assets and shows how efficiently management uses all assets, regardless of financing source, to generate earnings.

• Return on Equity (ROE): Net Income / Average Shareholders’ Equity. Highlights how efficiently owners’ capital is used to create earnings.

Key Term: return on equity (ROE)
ROE is net income divided by average shareholders’ equity, used to assess the return generated on shareholders’ investment.

When calculating ROA and ROE, CFA questions typically use average balances (beginning plus ending, divided by two) to reflect the assets or equity employed during the period. If only one balance is given, use that, but be alert to wording such as “average total assets.”

In practice, ROA and ROE can also be defined in slightly different ways:

• Some analysts use EBIT (or operating profit) in the numerator of ROA to focus on returns from operations before financing and taxes. This is sometimes called operating ROA.
• Some versions of ROE adjust net income for items attributable to preference shareholders or non-controlling interests.

On the exam, use the formula specified in the question stem or in any exhibits.

Key Term: asset turnover
Asset turnover is revenue divided by average total assets and measures how efficiently a company uses its asset base to generate sales.

A related efficiency measure is asset turnover, which you will see again in the DuPont decomposition of ROE and in the relationship:

This equality makes it clear that a firm can improve ROA either by raising margins or by using its assets to generate more sales.

Alternative profit measures and margins

Beyond the three core margins, analysts sometimes refer to additional margins. At Level 1 you should at least recognize:

• gross margin: focuses on production or direct cost efficiency;
• operating margin: includes overhead and selling costs;
• pretax margin: income before tax / revenue (less common in exam questions);
• net margin: bottom-line profitability.

A very commonly used additional measure is the EBITDA margin:

Key Term: EBITDA margin
EBITDA margin is earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by revenue and indicates profitability from operations before non-cash charges and financing and tax effects.

EBITDA margin is useful for comparing firms with different depreciation policies or asset ages because it strips out depreciation and amortization. It is widely used in credit analysis and in valuation multiples (for example, EV/EBITDA), though at Level 1 you mainly need to understand the intuition and basic formula.

Two further return measures you may encounter are:

Key Term: operating return on assets (operating ROA)
Operating return on assets is operating profit (EBIT) divided by average total assets and measures how effectively assets generate operating earnings before financing and tax effects.

Key Term: return on total capital
Return on total capital is EBIT divided by average total capital, where total capital equals short-term interest-bearing debt plus long-term debt plus shareholders’ equity; it evaluates how efficiently all long-term providers of capital are rewarded.

Operating ROA and return on total capital are especially relevant when comparing firms with different capital structures because they focus on performance before interest expense.

The exam may give you an income statement where some items (for example, restructuring charges or asset impairments) are clearly non-recurring. These can distort margins. Questions may ask you to comment on “normalized” or “core” profitability, in which case you should think about whether to exclude one-off gains or losses conceptually (you will not be asked to recompute financial statements, just to interpret).

Interpreting profitability ratios

When interpreting profitability ratios:

• compare to prior years (time-series or trend analysis);
• compare to peers and industry averages (cross-sectional analysis);
• link changes to fundamentals.

Some common interpretations are:

• Rising gross margin may signal:

  • better purchasing terms;
  • higher selling prices;
  • a shift towards higher-margin products or services.

  However, it might also reflect capitalization of costs that were previously expensed (for example, capitalizing development costs), so always consider accounting policy changes.

• Falling gross margin may indicate:

  • rising input costs (raw materials, labour);
  • increased competition limiting pricing power;
  • inventory write-downs or obsolescence.

• Operating margin isolates operating cost control:

  • If gross margin is stable but operating margin falls, overhead (selling, general, administrative, R&D) is rising faster than sales.
  • If both gross and operating margins move in the same direction, the driver may be at the production level.

• Net margin is influenced by:

  • operating performance;
  • financing structure (interest expense);
  • tax rates and one-off items.

  A decline in net margin with stable operating margin might simply reflect higher interest costs from increased debt or a higher effective tax rate.

• ROA links profitability to the asset base:

  • High ROA suggests efficient asset use or high margins, or both.
  • A low ROA can reflect thin margins, inefficient use of assets (low asset turnover), or a very capital-intensive business.

• ROE shows returns to common shareholders:

  • High ROE can be attractive, but may be boosted by high leverage rather than strong operations.
  • Very high ROE with volatile earnings or weak coverage ratios may be unsustainable.

In practice, analysts often examine a group of profitability ratios together. For example:

• If both net margin and ROA increase, it is likely that margins improved; asset turnover may or may not have changed.
• If ROA rises while net margin is flat, asset turnover has improved: the company is generating more sales per unit of assets.
• If ROE rises but ROA and margins are unchanged, increased financial leverage is probably the cause.

Being able to connect these movements is frequently tested in short item sets.

DuPont decomposition of ROE

Because ROE is central for equity investors, it is often decomposed using the DuPont identity.

The basic three-part DuPont decomposition is:

where:

• Net profit margin = Net income / Sales
• Asset turnover = Sales / Average total assets
• Financial leverage (equity multiplier) = Average total assets / Average equity

Key Term: financial leverage
Financial leverage (equity multiplier) is total assets divided by total equity and indicates how much assets are supported by each currency unit of equity.

This decomposition helps identify whether ROE is driven by:

• profitability (net margin);
• efficiency (asset turnover);
• leverage (equity multiplier).

You should also be aware of the extended five-part DuPont formula, which further separates tax and interest effects:

This version allows you to see whether changes in ROE come from:

• tax effects (tax burden);
• financing choices (interest burden);
• operating profitability (EBIT margin);
• asset use efficiency (asset turnover);
• leverage (financial leverage).

At Level 1, you are more likely to apply the three-part version numerically, but you should conceptually understand that ROE can be decomposed further.

Business model examples

• Supermarkets typically have:

  • low net margins;
  • high asset turnover (stock moves quickly, stores are heavily used);
  • moderate leverage.

  Their ROE often comes from efficiency and volume.

• Luxury goods producers often have:

  • high net margins;
  • lower asset turnover;
  • sometimes modest leverage.

  Their ROE comes mainly from margins.

Components and variations of ROA and ROE

Although the basic DuPont formula above is common, you should understand the intuition:

• Net profit margin answers: “For each dollar of sales, how much profit is left for shareholders?”
• Asset turnover answers: “For each dollar of assets, how much revenue is generated?”
• Financial leverage answers: “For each dollar of equity, how many dollars of assets are employed?”

A company can improve ROE by:

• improving margins (raising prices, reducing costs);
• using assets more productively (higher turnover);
• increasing leverage (financing more of its assets with debt).

Only the first two are operational improvements. Increasing leverage raises risk: interest must be paid regardless of sales, so profits become more volatile. Exam questions often test whether you can distinguish between quality improvements in ROE (margin and turnover) and riskier improvements (higher leverage).

Changes in ROA also need care:

• A rising ROA with stable margins usually means the company is using assets more efficiently (higher turnover) or has reduced excess assets.
• A falling ROA with unchanged margins may indicate that the firm invested heavily in assets (for example, new factories) that have not yet generated corresponding sales.

Another subtle point is that measured ROA can differ across firms purely because of accounting choices:

• Firms using accelerated depreciation will have lower carrying amounts for older fixed assets, increasing ROA relative to firms using straight-line depreciation, all else equal.
• Firms that expense development costs (e.g., many US GAAP software firms) will have fewer intangible assets on the balance sheet, which can make ROA appear higher than for firms that capitalize and amortize such costs.

Qualitative understanding of these effects is often enough to select the best answer in exam questions about comparability.

Effect of share repurchases on ROE

Level 1 questions sometimes connect capital structure actions to profitability ratios. For example, when a firm repurchases shares:

• equity decreases (denominator of ROE falls);
• if earnings are unchanged, ROE mechanically increases;
• leverage ratios (such as debt-to-equity) also rise if the repurchase was debt-financed.

You should be able to recognize that a higher ROE following a leveraged share buyback does not necessarily represent improved operating performance; it may simply reflect greater financial risk.

Worked Example 1.1

A company reports net income of 500, gross profit of 1,000, revenue of 5,000, average assets of 2,500, and average equity of 1,250. Calculate Gross Profit Margin, Net Profit Margin, ROA, and ROE.

Answer:

• Gross Profit Margin = 1,000 / 5,000 = 0.20 or 20%
• Net Profit Margin = 500 / 5,000 = 0.10 or 10%
• ROA = 500 / 2,500 = 0.20 or 20%
• ROE = 500 / 1,250 = 0.40 or 40%

Asset turnover = 5,000 / 2,500 = 2.0 times, and the financial leverage ratio (equity multiplier) is 2.0 = 2,500 / 1,250.
ROE using DuPont: 10% (margin) × 2.0 (turnover) × 2.0 (leverage) = 40%.
A 40% ROE alongside a 20% ROA indicates that leverage (equity multiplier of 2.0) is amplifying returns to equity holders. If leverage fell (for example, equity increased), ROE would decline unless margins or turnover improved.

Comparing profitability across companies

When comparing profitability ratios:

• always compare firms in similar industries or with similar business models;
• consider business cycles: cyclical firms may have temporarily depressed margins during downturns;
• consider asset age: firms with newer assets may show lower ROA because assets are recorded at higher carrying amounts.

Also keep in mind:

• A company can have high net margin but low ROA if it holds a large amount of underutilized assets (for example, excess cash, unused property).
• Another company may have lower margins but very high turnover, leading to a higher ROA.

Ratios must therefore be interpreted together, not individually.

Worked Example 1.2

Two firms operate in the same industry:

• Firm X: Net income = 120, Sales = 1,000, Average total assets = 800, Average equity = 400
• Firm Y: Net income = 120, Sales = 600, Average total assets = 400, Average equity = 300

Calculate net margin, asset turnover, ROA, and ROE for each firm. Comment on the differences.

Answer:
Firm X:

• Net profit margin = 120 / 1,000 = 12%
• Asset turnover = 1,000 / 800 = 1.25
• ROA = 120 / 800 = 15%
• ROE = 120 / 400 = 30%

Firm Y:

• Net profit margin = 120 / 600 = 20%
• Asset turnover = 600 / 400 = 1.50
• ROA = 120 / 400 = 30%
• ROE = 120 / 300 = 40%

Firm Y has the same net income with lower sales and a smaller asset base. It achieves higher margins and higher asset turnover, resulting in a much higher ROA (30% versus 15%). Its ROE is also higher, partly because it uses more leverage (assets 400 against equity 300 implies more debt). Overall, Firm Y is using both its pricing power and its assets more efficiently, but also takes on more financial risk.

In exam questions, you may be asked which firm is more efficient operationally (look at ROA, margins, and turnover) and which one is riskier in terms of financing (look at leverage).

Profitability ratios and earnings quality

Profitability ratios also give clues about earnings quality:

• Large jumps in net margin driven by one-time gains (for example, sale of a building) are not sustainable.
• Falling gross margin combined with rising sales may suggest the firm is discounting heavily to boost volume; if this is not temporary, future profitability may be at risk.
• Very high reported ROE with low interest coverage or rising leverage may indicate aggressive use of debt that could pressure future earnings.

Analysts also pay attention to the volatility of profitability measures. A firm whose net margin oscillates between 5% and 20% from year to year may be riskier than a firm that consistently earns 10%, even if the long-run average is similar. Volatile margins can make it harder to service fixed obligations such as interest and lease payments.

In qualitative sections of exam questions, be prepared to distinguish sustainable improvements in profitability (for example, better efficiency, structurally higher margins) from temporary or riskier sources (for example, one-off gains or higher leverage).

Liquidity Ratios

Liquidity ratios assess a company’s ability to meet its short-term obligations. They are particularly important for creditors and short-term lenders, and they help identify whether a profitable firm might still face cash flow problems.

The main liquidity ratios are:

• current ratio;
• quick (acid-test) ratio;
• cash ratio;
• defensive interval ratio;
• cash conversion cycle.

Basic balance sheet liquidity ratios

• Current Ratio: Current Assets / Current Liabilities. Indicates whether current assets exceed current liabilities.

Key Term: current ratio
The current ratio is the ratio of current assets to current liabilities; it is a primary measure of short-term liquidity at a point in time.

• Quick Ratio (Acid-Test Ratio): (Cash + Marketable Securities + Receivables) / Current Liabilities. Excludes inventory and other less liquid current assets for a more rigorous test of liquidity.

Key Term: quick ratio
The quick ratio is (cash + marketable securities + receivables) divided by current liabilities and focuses on the most liquid current assets.

• Cash Ratio: (Cash + Marketable Securities) / Current Liabilities. The most conservative measure; assumes only cash and near-cash securities are available.

Key Term: cash ratio
The cash ratio is (cash + marketable securities) divided by current liabilities and measures a firm’s ability to meet short-term obligations using only cash and cash equivalents.

These ratios use balance sheet data at a point in time, often year-end. For liquidity analysis that spans several years, it is useful to look at the trend in these ratios rather than a single value, because firms sometimes engage in “window dressing” (temporarily improving ratios just before the reporting date, for example by delaying purchases or using short-term borrowings cleverly).

A ratio above 1 suggests that the company can cover its short-term debts with liquid assets, but “higher is better” is not always true:

• Very low liquidity (for example, current ratio below 1, quick ratio far below 1) may signal difficulty in paying suppliers and lenders.
• Extremely high liquidity (for example, current ratio 4–5 with a lot of idle cash) may indicate inefficient use of resources: cash and short-term investments might be earning very low returns.

Analysts also look at working capital.

Key Term: net working capital
Net working capital is usually defined as current assets minus current liabilities; some analyses exclude cash, marketable securities, and short-term debt to focus on operating working capital.

Positive net working capital generally supports liquidity, but its composition matters:

• Working capital tied up in slow-moving inventory or overdue receivables is less useful than cash.
• Some textbooks and exam questions define operating net working capital as:
  • (Accounts receivable + Inventory + Prepaid expenses) minus (Accounts payable + Accrued liabilities), excluding cash and short-term debt.

The corporate issuers reading also uses this “operating” definition when discussing net working capital. Read questions carefully to see which definition is intended.

Worked Example 1.3

A firm has 500 in cash, 1,500 in receivables, 2,000 in inventory, and 1,800 in current liabilities. Compute the current, quick, and cash ratios.

Answer:

• Current Ratio = (500 + 1,500 + 2,000) / 1,800 = 4,000 / 1,800 ≈ 2.22
• Quick Ratio = (500 + 1,500) / 1,800 = 2,000 / 1,800 ≈ 1.11
• Cash Ratio = 500 / 1,800 ≈ 0.28

The current ratio well above 1 suggests that the firm can cover near-term obligations, but closer inspection shows that only 28% of current liabilities are covered by cash and marketable securities. The rest depends on converting receivables and inventory into cash. If receivables are slow to collect or inventory is difficult to sell, actual liquidity may be weaker than the current ratio alone suggests.

Additional liquidity metrics: defensive interval and cash conversion cycle

Beyond the basic ratios, the curriculum also introduces measures that explicitly consider the timing of cash flows.

Key Term: defensive interval ratio
The defensive interval ratio equals (cash + marketable securities + receivables) divided by average daily cash expenditures and estimates how many days a firm can cover cash operating expenses using only existing liquid assets.

Average daily cash expenditures can be approximated by:

• taking total cash operating expenses for the period (COGS, selling, general and administrative expenses, and R&D);
• subtracting non-cash charges like depreciation and amortization;
• dividing by the number of days in the period.

A higher defensive interval ratio indicates that the company can continue paying its bills for more days without needing additional cash inflow or financing. This is similar in spirit to the “burn rate” used for start-up firms.

Key Term: cash conversion cycle
The cash conversion cycle (net operating cycle) is the number of days from investing cash in inventory until receiving cash from customers, usually calculated as:
Cash conversion cycle = Days of inventory on hand + Days sales outstanding − Number of days of payables.

The cash conversion cycle relies on three activity measures:

Key Term: days of inventory on hand (DOH)
Days of inventory on hand is approximately (average inventory ÷ cost of goods sold) × 365 and measures how many days inventory remains in stock before being sold.

Key Term: days sales outstanding (DSO)
Days sales outstanding is approximately (average trade receivables ÷ credit sales) × 365 and measures the average number of days it takes to collect cash from customers.

Key Term: number of days of payables
The number of days of payables is approximately (average trade payables ÷ purchases or COGS) × 365 and measures how long, on average, the firm takes to pay suppliers.

A shorter or declining cash conversion cycle indicates that the firm recovers its investment in working capital more quickly and generally has better liquidity. An unusually long or rising cash conversion cycle can be a warning of liquidity stress, slow collections, or obsolete inventory.

Be aware that some very strong retailers (for example, large supermarkets) may have a negative cash conversion cycle: they collect cash from customers immediately but pay suppliers later. This is usually a sign of strong bargaining power and a business model that generates liquidity.

Worked Example 1.4

A company reports the following for the year:

• Cash = 200, Marketable securities = 100, Receivables = 300
• Annual cash operating expenses (after removing depreciation) = 1,460
• Days of inventory on hand = 40
• Days sales outstanding = 30
• Number of days of payables = 25

Calculate the defensive interval ratio and the cash conversion cycle.

Answer:

• Average daily cash expenditures = 1,460 / 365 = 4
• Defensive interval ratio = (200 + 100 + 300) / 4 = 600 / 4 = 150 days

The company can cover about 150 days of operating expenses using only existing liquid assets.

• Cash conversion cycle = 40 + 30 − 25 = 45 days

The firm must finance inventory and receivables for approximately 45 days before receiving cash. A 45-day cash conversion cycle is moderate. Management could improve liquidity by reducing inventory days, collecting receivables faster, or negotiating longer payment terms with suppliers.

Liquidity in practice: asset liquidity versus firm liquidity

The curriculum distinguishes between:

• liquidity of individual assets or liabilities, which depends on how quickly they can be converted to cash (for assets) or when they must be settled (for liabilities); and
• liquidity of the firm, which depends on the overall ability to meet short-term obligations as they fall due.

Cash is the most liquid asset. Marketable securities are usually highly liquid, while inventory and certain prepayments are less liquid. On the liability side, accounts payable due in a few days are more pressing than a short-term loan due next month.

Firms typically list assets and liabilities on the balance sheet in order of liquidity (for assets) and maturity (for liabilities), allowing analysts to quickly assess short-term cash needs and resources.

Liquidity for an issuer therefore depends on:

• the amount of current assets and liabilities;
• the composition of current assets (how much is in cash versus inventory);
• the cash conversion cycle and working capital management;
• access to external financing.

Liquidity in practice: sources, drags, and pulls

From a credit analyst’s standpoint, liquidity depends not only on ratios but also on broader cash flow patterns.

Primary sources of liquidity are those that can be used in the normal course of business without fundamentally changing the firm’s operations. They include:

• cash and marketable securities on hand;
• cash flow from operations;
• available committed lines of credit and other short-term borrowing.

Secondary sources of liquidity involve actions that may change the size or scope of the business or its capital structure:

• sale of longer-term assets (for example, property);
• renegotiation of debt terms;
• issuing new equity.

These secondary sources are typically more costly and may be used only in a liquidity crisis.

Negative forces on liquidity are often described as drags and pulls:

• Drags on liquidity (delay or reduce cash inflows):

  • uncollected receivables and rising days sales outstanding;
  • obsolete or slow-moving inventory;
  • borrowing constraints (difficulty accessing credit, tighter terms);
  • general economic downturn reducing customer payments.

• Pulls on liquidity (accelerate cash outflows):

  • making payments to suppliers or employees earlier than required without benefit;
  • reduced credit limits from suppliers, forcing more cash purchases;
  • limits on short-term lines of credit;
  • chronic low cash balances leading to expensive emergency borrowing.

Effective liquidity management aims to reduce drags (accelerate cash inflows) and avoid unnecessary pulls (delay cash outflows to the latest date consistent with contract terms).

Worked Example 1.5

Two companies have identical current ratios of 2.0:

• Company A:

  • Current assets: 1,000 (Cash 600, Receivables 200, Inventory 200)
  • Current liabilities: 500

• Company B:

  • Current assets: 1,000 (Cash 50, Receivables 350, Inventory 600)
  • Current liabilities: 500

Both have a current ratio of 1,000 / 500 = 2.0. Which company is more liquid?

Answer:
Company A is more liquid. Although both companies have the same current ratio, A holds a much larger proportion of its current assets in cash (600 of 1,000) and smaller amounts in inventory. Company B relies heavily on inventory (600 of 1,000), which may be slow or costly to convert to cash quickly.

This example illustrates why you should not rely on the current ratio alone. Quick and cash ratios, together with information about receivables and inventory turnover, provide a more accurate picture of liquidity.

Liquidity measurement, industry differences, and the exam

For exam purposes, be comfortable with:

• computing current, quick, cash, and defensive interval ratios;
• calculating the cash conversion cycle when given turnover ratios or days measures;
• interpreting whether liquidity is improving or worsening over time.

Also be aware that:

• The level of liquidity considered “adequate” differs between industries. A supermarket with very fast inventory turnover and cash sales can operate safely with a lower current ratio than a construction firm with slow-moving work-in-progress.
• Large firms with strong credit ratings can operate with thinner liquidity buffers because they have reliable access to external funding; small firms may need higher cash balances.

Questions may also test your understanding of how changes in working capital policies affect liquidity. For example:

• Relaxing credit terms may increase sales but also increase receivables and days sales outstanding, lengthening the cash conversion cycle and raising short-term funding needs.
• Tightening inventory management usually reduces days of inventory on hand and improves liquidity, but if taken too far, may lead to stock-outs and lost sales.

Some exam vignettes show a firm with a negative cash conversion cycle. This is not automatically a red flag: many strong retailers receive cash from customers before paying suppliers, which actually strengthens liquidity. The key is whether payables days have increased because of strong bargaining power or because the firm is simply unable to pay suppliers on time (in which case other ratios, such as deteriorating interest coverage, usually signal distress).

Solvency Ratios

Solvency ratios show a company’s ability to meet long-term obligations and its degree of financial gearing. These ratios are closely monitored by credit rating agencies, long-term lenders, and bond investors. Key solvency ratios in the CFA syllabus include:

• debt-to-equity ratio;

• debt ratio;

• interest coverage ratio;

• long-term debt-to-equity ratio;

• financial leverage (equity multiplier).

• Debt-to-Equity Ratio: Total Debt / Total Equity. Shows the degree of financial gearing.

Key Term: debt-to-equity ratio
The debt-to-equity ratio is total debt divided by total shareholders’ equity and measures the extent to which the company is financed by creditors versus owners.

• Debt Ratio: Total Debt / Total Assets. Proportion of assets financed by debt.

Key Term: debt ratio
The debt ratio is total debt divided by total assets and indicates the percentage of the firm’s assets financed by debt.

• Interest Coverage Ratio: EBIT / Interest Expense. Reveals how easily interest payments are covered by operating profit; often called the times interest earned ratio.

Key Term: interest coverage ratio
The interest coverage ratio is profit before interest and taxes (EBIT) divided by interest expense and measures the margin of safety for making interest payments.

In practice, analysts also use narrower or broader leverage ratios:

Key Term: long-term debt-to-equity ratio
The long-term debt-to-equity ratio is long-term interest-bearing debt divided by shareholders’ equity and focuses on the proportion of permanent capital provided by long-term creditors versus owners.

Key Term: debt-to-capital ratio
The debt-to-capital ratio is total debt divided by total capital, where total capital equals total debt plus total equity; it measures the share of permanent financing that is debt.

On the exam, “debt” in these ratios usually refers to interest-bearing liabilities: short-term borrowings, long-term loans, bonds, and similar instruments. Non-interest-bearing liabilities such as accounts payable are typically not included unless the question states otherwise.

Higher gearing increases financial risk because fixed interest and principal payments must be met even when earnings are low. However, it can also increase ROE when returns on assets exceed the cost of debt, as you saw in the DuPont analysis.

Worked Example 1.6

A company reports EBIT of 480, interest expense of 80, total debt of 1,600, total equity of 600, and total assets of 2,200. Compute the debt-to-equity, debt ratio, and interest coverage ratio.

Answer:

• Debt-to-Equity = 1,600 / 600 = 2.67
• Debt Ratio = 1,600 / 2,200 ≈ 0.73 or 73%
• Interest Coverage Ratio = 480 / 80 = 6 times

Debt finances about 73% of assets and is 2.67 times equity, indicating high leverage. However, EBIT covers interest 6 times, which is generally comfortable. A sustained fall in EBIT (for example, during a recession) could quickly reduce this margin of safety.

A low interest coverage ratio (for example, below 2) signals elevated default risk and would concern lenders and rating agencies. Exam questions may ask which firm is riskier given coverage ratios.

In addition to EBIT-based coverage, practitioners often compute EBITDA interest coverage:

This ratio is less sensitive to depreciation and amortization, and so is especially useful in capital-intensive industries. While this version is more common in practice than in exam calculations, you should understand its interpretation: the higher the ratio, the greater the buffer to pay interest.

Interpreting solvency and leverage

When analysing solvency ratios:

• A high debt-to-equity or high debt ratio indicates greater dependence on debt financing and a thinner equity buffer to absorb losses.
• Declining interest coverage over time is a warning sign, especially if leverage is increasing at the same time.
• Compare leverage and coverage to industry norms:
  • Regulated utilities and telecom companies often operate with higher leverage because their cash flows are relatively stable and predictable.
  • Highly cyclical industries (for example, construction, airlines) typically require stronger coverage ratios to compensate for more volatile earnings.

Leverage has two main effects:

• It amplifies ROE:
  • When return on assets exceeds the after-tax cost of debt, adding leverage increases ROE.
  • When return on assets falls below the cost of debt, leverage reduces ROE sharply and can lead to losses.
• It increases risk:
  • Interest and principal payments are contractual. A highly leveraged firm has less flexibility to absorb downturns without breaching covenants or defaulting.

From an equity investor’s viewpoint, high leverage can look attractive in good times due to high ROE. From a debt investor’s viewpoint, the same leverage increases default risk and may justify a higher required yield.

One additional measure you may see is debt-to-EBITDA:

Higher values indicate that it would take more years of current EBITDA to pay off debt (ignoring interest and taxes), signalling greater leverage. Again, you are unlikely to be required to compute this ratio at Level 1, but understanding its meaning can help with conceptual questions.

Solvency, operating leverage, and profit stability

The curriculum also highlights how operating leverage (fixed versus variable operating costs) interacts with financial leverage (debt).

Key Term: operating leverage
Operating leverage describes the extent to which a firm’s operating costs are fixed rather than variable; higher operating leverage means a given percentage change in sales leads to a larger percentage change in operating income.

• A firm with high operating leverage has a high proportion of fixed costs. A small change in sales causes a larger change in operating income.
• If such a firm also has high financial leverage, earnings to equity holders can be very volatile:
  • profits rise quickly when sales increase;
  • but fall sharply, or turn into losses, when sales decline.

Before extending further debt, lenders look not only at the level of existing debt but also at the variability of profits. A firm with more variable operating income may be offered debt only at a higher cost or may be constrained to lower leverage.

A simple illustration shows the effect:

• A firm with mostly fixed costs (high operating leverage) might see ROE move from 50% to 10% when sales fall 25%.
• A firm with mainly variable costs (low operating leverage) might see ROE move from 30% to 18% for the same drop in sales.

Debt investors prefer the second pattern because profits remain more stable in a downturn, making interest and principal payments more secure.

Worked Example 1.7

Consider two firms, A and B, both with assets of 100 and the same operating income of 30:

• Firm A: Equity = 80, Debt = 20, interest expense = 2
• Firm B: Equity = 40, Debt = 60, interest expense = 9

Ignore taxes. Calculate profit, interest coverage, and ROE for each firm.

Answer:
Firm A:

• Profit = Operating income − Interest = 30 − 2 = 28
• Interest coverage = 30 / 2 = 15 times
• ROE = 28 / 80 = 35%

Firm B:

• Profit = 30 − 9 = 21
• Interest coverage = 30 / 9 ≈ 3.3 times
• ROE = 21 / 40 = 52.5%

Firm B’s ROE is significantly higher because it uses more debt and less equity. However, its interest coverage is much weaker: only about 3.3 times. Firm A has lower ROE but a very strong coverage ratio. Debt investors are likely to view Firm A as the safer borrower and may require a lower yield on its debt.

Exam questions may ask which firm’s equity is riskier, which is more likely to be downgraded by rating agencies, or which would be able to take on additional debt.

Worked Example 1.8

Two companies, C and D, operate in the same industry and have the following data:

• Company C: Total assets = 1,000; Total debt = 700; Equity = 300; EBIT = 140; Interest expense = 35
• Company D: Total assets = 1,000; Total debt = 400; Equity = 600; EBIT = 120; Interest expense = 20

Calculate the debt-to-equity ratio and interest coverage for each, and briefly comment on their solvency positions.

Answer:
Company C:

• Debt-to-equity = 700 / 300 ≈ 2.33
• Interest coverage = 140 / 35 = 4.0 times

Company D:

• Debt-to-equity = 400 / 600 ≈ 0.67
• Interest coverage = 120 / 20 = 6.0 times

Company C is much more leveraged (debt more than twice equity) and has weaker interest coverage. Company D has a more conservative capital structure and stronger coverage. If the industry is cyclical, Company C’s higher leverage may be risky. Equity investors may favour C’s higher potential ROE, but bond investors would likely view D as the safer issuer.

Exam Warning

On the exam, do not confuse liquidity ratios (current, quick, cash, defensive interval, cash conversion cycle) with solvency ratios (debt-to-equity, debt ratio, interest coverage, long-term debt-to-equity, debt-to-capital). Liquidity ratios assess short-term risk and working capital management; solvency ratios assess long-term financial risk and gearing.

Also be careful not to assume that high ROE automatically means low risk. Always check leverage and coverage ratios.

Interpreting and Applying Ratio Analysis

Ratios must be interpreted in context rather than in isolation. A single ratio rarely provides a complete picture. CFA Level 1 questions often give you a small table of ratios and a few sentences of qualitative information; you are expected to link them logically.

Time-series and cross-sectional analysis

• Time-series (trend) analysis:

  • Track ratios over several years for the same company.
  • Look for patterns: are margins improving, stabilising, or deteriorating? Is leverage creeping up?
  • Short-term fluctuations may reflect one-off events; persistent trends are more informative.
  • Example: Rising debt ratios and falling interest coverage over multiple years are a red flag that long-term solvency is weakening.

• Cross-sectional analysis:

  • Compare a firm’s ratios with those of similar companies or with industry averages.
  • A current ratio of 1.2 might be adequate in an industry where inventory turns very quickly but low in an industry with slow-moving goods.
  • A debt-to-equity ratio of 2.0 might be normal for a regulated utility but aggressive for a technology start-up with uncertain cash flows.

On the exam, you may see a table of company and industry ratios and be asked to identify strengths and weaknesses or to explain why a particular ratio is above or below the industry average.

In practice, analysts also perform “benchmarking” against a peer group and against the firm’s own targets or bank covenants. For example, a loan agreement may require that the firm maintain a current ratio above 1.5 and an interest coverage ratio above 3. Breaking these covenants can trigger penalties or loan repayment, so watching the trend in ratios relative to such thresholds is critical.

Linking profitability, liquidity, and solvency

Ratios tell a more complete story when considered together:

• A firm with high ROE, low current ratio, and high debt-to-equity likely uses significant leverage and may face liquidity pressure. Profitability looks strong, but short-term and long-term risks are elevated.
• A firm with moderate ROE, strong liquidity, and low leverage may be financially sound but not using capital aggressively. Management might be holding excess cash, which dilutes ROE, or may be operating in a low-margin industry.
• Worsening liquidity ratios, a lengthening cash conversion cycle, and declining interest coverage together may signal impending financial distress, even if profit margins remain stable. Longer collection periods and slower inventory turnover can quickly translate into cash shortages.

Analysts also connect profitability and efficiency through the DuPont framework:

• Falling ROE might result from:
  • lower net margins (cost pressures, pricing issues);
  • reduced asset turnover (underutilized assets, excess inventory);
  • reduced leverage (deleveraging, more equity issuance).

Decomposing ROE with DuPont helps pinpoint the driver:

• If margins fall but turnover and leverage are stable, the issue is operating performance.
• If turnover falls, asset usage is the problem.
• If leverage falls, ROE may decline even if operations are stable, but risk is reduced.

Worked Example 1.9

A firm has the following data:

• Net income = 120
• Sales = 1,000
• Average total assets = 600
• Average equity = 400

Calculate net profit margin, asset turnover, financial leverage, and ROE, and verify the DuPont relationship.

Answer:

• Net profit margin = 120 / 1,000 = 0.12 or 12%
• Asset turnover = 1,000 / 600 ≈ 1.67 times
• Financial leverage (equity multiplier) = 600 / 400 = 1.5
• ROE (direct) = 120 / 400 = 0.30 or 30%

DuPont check: ROE = 12% × 1.67 × 1.5 ≈ 0.30 or 30%.

The high ROE is the combined result of healthy margins, efficient asset use, and moderate leverage. If leverage rose to 2.0 while margins and turnover stayed the same, ROE would increase to about 40%, but financial risk would also rise (higher debt and higher interest obligations).

Ratio analysis, working capital policies, and strategy

Ratio analysis also reveals how management choices affect risk and return:

• Aggressive working capital policies:

  • low levels of inventory and receivables relative to sales;
  • greater reliance on short-term debt to finance current assets.

  These can raise ROE (less capital tied up) but increase liquidity and refinancing risk. For example, an aggressive policy may give a shorter cash conversion cycle but also require frequent refinancing of short-term obligations.

• Conservative working capital policies:

  • higher cash balances, more inventory, generous receivables terms;
  • more long-term financing of current assets.

  These policies typically reduce risk but may depress ROE because more capital sits in low-yielding assets.

A moderate working capital policy tries to match financing with asset needs:

• permanent current assets (for example, base inventory levels) funded with long-term sources;
• seasonal or cyclical variations funded with short-term borrowing.

This “matching” approach aims to balance cost and risk.

A change in sales strategy (for example, more generous credit to customers to boost sales) will show up in:

• higher sales and potentially higher margins and ROA;
• higher accounts receivable and days sales outstanding;
• a longer cash conversion cycle;
• higher short-term funding needs.

On the exam, you may be asked to predict the direction of change in liquidity and solvency ratios when a firm changes its credit policy, inventory policy, or financing mix.

Limitations and judgment in ratio analysis

Ratio analysis has important limitations, many of which are testable at Level 1:

• Accounting differences:

  • Different depreciation methods (straight-line versus accelerated) affect asset values and profit.
  • Different inventory methods (FIFO versus weighted average) affect COGS, inventory, and profit, especially when prices are changing.
  • Different revenue recognition policies can shift timing of sales and profit.

  These differences can make direct comparison between firms difficult. Analysts may have to adjust reported numbers for comparability.

• Point-in-time nature:

  • Liquidity ratios based on year-end balances can be distorted by seasonality.
  • Management may engage in “window dressing,” temporarily paying down liabilities or delaying purchases just before the reporting date to improve ratios.

• Mixed asset quality:

  • The current ratio treats all current assets as equally liquid, although inventories and some receivables may be slow to convert into cash.
  • Quick and cash ratios partially address this, but analysts must still consider turnover measures and aging of receivables.

• Temporary versus persistent changes:

  • A one-off restructuring charge can depress profit margins in a single year without indicating a long-term problem.
  • Persistent declines in margins, turnover, or coverage over several years are much more concerning.

• Business mix and diversification:

  • For conglomerates operating in multiple industries, aggregate ratios may mask significant differences across segments.
  • Segment disclosures often provide better information; analysts can compare each segment to the relevant industry.

• Inflation and changes in price levels:

  • In periods of high inflation, asset values recorded at historical cost may be understated relative to current replacement cost, affecting ROA and leverage ratios.
  • Sales and income are recorded in current currency units, potentially making profitability look higher relative to the understated asset base.

• Off-balance-sheet obligations:

  • Some obligations, such as certain guarantees or lawsuits, may not appear as debt on the balance sheet but still represent potential claims on cash.
  • For financial institutions in particular, contingent liabilities (for example, credit lines and guarantees) can significantly affect liquidity and solvency in a crisis.

Because of these limitations, analysts should:

• use multiple ratios together rather than relying on a single measure;
• incorporate qualitative information (competitive position, management quality, regulatory environment);
• focus on patterns and relationships rather than exact numeric thresholds;
• be cautious when comparing across firms with different accounting policies or operating environments.

For exam questions, you may be asked why ratios may not be directly comparable or which limitation is most relevant in a given scenario.

Common exam-style pitfalls

Some frequent pitfalls tested at Level 1 include:

• Confusing liquidity and solvency:

  • current and quick ratios relate to short-term obligations, not long-term leverage;
  • debt-to-equity and interest coverage relate to long-term financing, not immediate cash needs.

• Misinterpreting a single ratio:

  • concluding that a high ROE always indicates strong performance, without checking leverage and coverage;
  • assuming a high current ratio always means strong liquidity, without considering asset composition or turnover.

• Ignoring the denominator:

  • interpreting changes in ROA or ROE without noticing that assets or equity changed significantly due to acquisitions, write-downs, or share repurchases.

• Forgetting to use averages:

  • when calculating ratios that mix income statement and balance sheet items (for example, ROA, asset turnover), exam questions often expect you to use average balances if provided.

Being alert to these issues helps you avoid traps and choose the best answer among plausible alternatives.

Summary

Financial ratios provide standardized measures for analysing profitability, liquidity, and solvency.

• Profitability ratios such as gross, operating, and net margins, ROA, ROE, EBITDA margin, operating ROA, and return on total capital reveal how effectively a company generates earnings from sales, assets, and capital. Decomposing ROE with the DuPont identity helps identify whether returns come from margins, efficiency, or leverage.
• Liquidity ratios including the current, quick, cash, and defensive interval ratios, along with the cash conversion cycle and related activity ratios, assess a firm’s capacity to meet short-term obligations and manage working capital. Understanding primary sources of liquidity, as well as drags and pulls, is important for evaluating sustainability.
• Solvency ratios such as the debt-to-equity ratio, debt ratio, financial leverage, long-term debt-to-equity, debt-to-capital, and interest coverage evaluate long-term financial risk and the sustainability of leverage. They indicate how much cushion equity provides and how easily the firm can service its debt.

Accurate calculation, consistent interpretation, and clear comparison are essential. Ratios should be analysed:

• over time for the same firm (trend analysis);
• against peer companies and industry benchmarks (cross-sectional analysis);
• in combination, linking profitability, liquidity, and solvency using frameworks such as DuPont.

Analysts must also recognize the limitations of ratio analysis, including accounting differences, point-in-time measures, inflation, business mix, and off-balance-sheet exposures, and avoid common exam mistakes such as confusing liquidity and solvency ratios or assessing ratios in isolation.

Key Point Checklist

This article has covered the following key knowledge points:

• Calculate and interpret profitability ratios: gross profit margin, operating margin, net profit margin, ROA, ROE, EBITDA margin, operating ROA, and return on total capital.
• Use the DuPont decomposition of ROE into net profit margin, asset turnover, and financial leverage, and interpret which component drives changes in ROE.
• Recognize the extended DuPont breakdown that separates tax burden, interest burden, and operating margin.
• Calculate and interpret liquidity ratios: current, quick, cash, and defensive interval ratios.
• Explain and apply the cash conversion cycle as a measure of working capital efficiency and liquidity, using days of inventory on hand, days sales outstanding, and number of days of payables.
• Distinguish between asset liquidity and firm liquidity and identify primary and secondary sources of liquidity, as well as drags and pulls on liquidity.
• Calculate and interpret solvency ratios: debt-to-equity, long-term debt-to-equity, debt ratio, debt-to-capital, financial leverage, interest coverage.
• Analyse ratios in context—compare across companies, time periods, and industries, and link profitability, liquidity, and solvency using frameworks such as DuPont.
• Recognize how changes in working capital policies or capital structure affect key ratios, the cash conversion cycle, and short-term funding needs.
• Understand limitations of ratio analysis, including accounting differences, point-in-time measures, inflation, business mix, and off-balance-sheet exposures, and avoid common exam mistakes such as over-relying on a single ratio.

Key Terms and Concepts

• ratio analysis
• profitability ratios
• liquidity ratios
• solvency ratios
• liquidity
• gross profit margin
• operating profit margin
• net profit margin
• return on assets (ROA)
• return on equity (ROE)
• asset turnover
• EBITDA margin
• operating return on assets (operating ROA)
• return on total capital
• financial leverage
• current ratio
• quick ratio
• cash ratio
• net working capital
• defensive interval ratio
• cash conversion cycle
• days of inventory on hand (DOH)
• days sales outstanding (DSO)
• number of days of payables
• debt-to-equity ratio
• debt ratio
• interest coverage ratio
• long-term debt-to-equity ratio
• debt-to-capital ratio
• operating leverage