Acing Financial Ratios on the CFA Exam
It's common on both the CFA Level 1 and Level 2 exams to see test questions asking you to answer how a given financial ratio changes in response to a change of value in a specific line item on either the balance sheet or income statement. Often these questions appear to require calculations, but in fact you may be able to intuit the correct answer (or at least eliminate one of the three options as definitely incorrect) by understanding how the numerator and denominator of the ratio changes in response.[1]
This can mnimize Candidate tendencies to make mistakes on these types of questions while also saving you a tremendous amount of time which you can spend on other problems throughout the test.
It can help to start with the main financial and solvency ratios listed in a table format:
The Major Liquidity and Solvency Ratios
Liquidity and Solvency Ratios |
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Liquidity Ratios |
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Ratio |
Numerator |
Denominator |
Current Ratio |
Current Assets |
Current liabilities |
Quick Ratio |
Cash + marketable securities + receivables |
Current liabilities |
Cash Ratio |
Cash + marketable securities |
Current liabilities |
Solvency Ratios |
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Long-term-debt-to-equity |
Total long-term debt |
Total equity |
Debt-to-equity ratio |
Total debt |
Total equity |
Total debt ratio |
Total debt |
Total assets |
Financial leverage ratio |
Total assets |
Total equity |
Or if it helps to have it a look a little nicer :)
(For a complete table of all the equations for liquidity, solvency, activity, and profitability ratios see this post)
Answering the CFA Financial Ratio Question
Once we've identified which ratio the CFA exam is asking us about, we first need to understand the variables being changed.
Then, our goal is to decide whether a given scenario changes the numerator, the denominator, or both.
For example if only the numerator increases (decreases) or if only the denominator decreases (increases) then we know the ratio has increased (decreased):
Using this method is powerful. Literally every single time you see this type of ratio question you should be able to state without getting into any math whether the variable has increased, decreased, or if the effect is inconclusive. This should let you eliminate one incorrect answer at a minimum (and often two). From there you may still need to do some math, but either way your odds of selecting the correct choice have increased.
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[1] Of course, you must know if that line item affects a given ratio in the first place for this to work. For that you can see our post on all of the Financial Statement Ratios you are likely to see on the CFA Level 1 exam.