Gostudymock3

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

Liquidity Ratios

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

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 :)

 

CFA Liquidity and Solvency Ratios

(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):

 How to think about financial ratios CFA L1

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