Financial Statement Ratios for CFA Level 1
Financial ratios are useful in comparing various parts of a company's financial statements against others in its industry, both to determine the company's overall financial position and to look at its relative performance. We typically use changes in ratios as flags or indicators that there may be an area that requires further analysis.
On the CFA Level 1 exam, expect to see dozens of questions that use ratios.
Some may require you to calculate a specific ratio, but questions are more likely to require you to link back deeper into the financial statements themselves before then tracing their effect on some of the underlying ratios. This isn't rocket science, but it will require you to have a firm grip on how the income statement, balance sheet, and other statements link to one another.
For our key tips on answering ratio questions see this post.
That said, you also need to understand the basics of how to use ratios, and which ratios are most commonly used for various purposes. Let's get into that now.
What do we analyze using financial ratios?
We can use ratios to:
- Estimate future earnings and cash flow
- Examine a firm’s flexibility with respect to capitalizing on new opportunities
- Benchmark the firm's performance against the competition
- Compare changes in the firm and industry over time
- Evaluate management’s performance
What are the main limitations of using financial ratios?
But ratios aren’t perfect. Limitations include the fact that:
- A single ratio isn’t very useful by itself. They need to be compared against historical performance or against the industry averages. There is no set value or ranges that define "good" either
- Comparing ratios for a firm that operates in multiple industries is very difficult (mostly because it is hard to find appropriate benchmarks)
- Definitions for a particular ratio can vary widely by analyst depending on how they classify the components of the ratio (numerator/denominator)
- Different accounting treatments at firms make cross-firm comparisons more difficult, and this is compounded across international borders (especially between IFRS and U.S. GAAP)
What is the significance of these limitations for financial analysis?
Because no single ratio is conclusive we need to compare many different ratios against a company’s stated objectives. This lets us draw a more accurate picture of whether the ratios are moving in lockstep with the company’s strategy. The nature of ratios also means we should compare those of one company against the rest of the industry.
An analyst must also remain aware that:
- Not all ratios are relevant for every industry
- It may be necessary to separate out individual business lines and create ratios for those. Note a business segment is defined as a separate business line or geographic unit that accounts for > 10% of a firm’s sales or assets
- The accounting methods used can impact ratios a lot
- The different lifecycle stages of a company might affect ratio values, even within the same industry
- The overall business cycle that the economy is in also impacts financial ratios
There is no true standard set of ratios, but the curriculum does introduce five broad buckets into which we can categorize ratios.
- Activity ratios – Measure how productive/efficient a company is in using its assets
- Liquidity ratios – Measure a firm’s ability to meet its short-term cash obligations
- Solvency ratios – Measure a firm’s financial leverage and ability to pay its long-term obligations
- Profitability ratios – Measures how efficient company is at turning sales into net profit
- Valuation ratios – Measure the quantity of an asset (or flow) for a specific piece of ownership. These are used to compare companies relative valuation
Note that ratios are not mutually exclusive, i.e. they can fall under more than one category.
Activity ratios measure how productive/efficient a company is in using its assets which is why they are sometimes known as operating efficiency ratios or asset utilization ratios. Note that the ratios that use a balance sheet value use the average vaue for a given period (beginning +ending values/2):
Liquidity ratios measure a firm’s ability to meet its short-term cash obligations. As we’ve covered, the first three ratios are only different in the assumed liquidity of the current assets we include in the numerator.
Solvency ratios measure a firm’s ability to meet long term commitments. They include debt ratios based on the balance sheet as well as coverage ratios based on the income statement.
Profitability ratios measure the overall performance of the firm relative to assets, equity, capital, or revenue. Calculating how profitable a firm is, in some respects at least, the holy grail. It is worth noting before introducing the different ratios that many of them use slightly different different definitions for types of earnings and profit. You need to understand and be able to calculate/differentiate between EBITDA, EBIT, and EBT for example.
Having covered in great depth the various ratios and the advantages and pitfalls of using them, let me end with a few observations.
- Expect to be tested extensively on permutations of using ratios across ALL of the financial statement readings in the CFA Level 1 curriculum
- Be able to relate the ratios to IFRS and GAAP treatment, capitalization vs. expensing of assets, and amortization/depreciation
- You should be able to look at these ratios and get a good sense of how/why the DuPont and extended DuPont equation can be used
- For many CFA exam questions around financial ratios, you may think you need to perform a calculation but if you understand the direction the numerator and denominator are moving you should be able to know whether the ratio will increase or decrease
- Memorization is and is not your friend when it comes to ratios. Memorize them, but also understand how they are derived