1.1 Financial Ratios and Valuation
Fundamental security analysis requires evaluating corporate balance sheets and income statements using standard financial ratios to gauge liquidity, solvency, profitability, and market valuation.
Key NASAA Exam Takeaways
- Current Ratio = Current Assets / Current Liabilities (measures short-term liquidity).
- Quick Ratio (Acid Test) = (Cash + Marketable Securities + Receivables) / Current Liabilities (excludes inventory).
- Debt-to-Equity Ratio = Total Debt / Total Shareholders' Equity (measures financial leverage).
- Price-to-Earnings (P/E) Ratio = Market Price per Share / Earnings per Share (EPS).
Liquidity vs. Solvency Ratios
Liquidity ratios assess a firm's ability to satisfy obligations due within one year, whereas solvency ratios evaluate long-term debt burden and structural capital integrity.
| Ratio | Formula | Normal Benchmark | Significance |
|---|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | > 1.5 - 2.0 | General short-term liquidity |
| Quick (Acid-Test) Ratio | (Cash + Equivalents + AR) / Current Liabilities | > 1.0 | Immediate liquidity without liquidating inventory |
| Debt-to-Equity | Total Debt / Shareholders' Equity | Industry dependent | Financial leverage; higher = higher default risk |
| Price-to-Book (P/B) | Stock Price / Book Value per Share | < 1.0 = Value signal | Compares market price to accounting net worth |
Acid-Test (Quick) Ratio Calculation
Apex Corp has Cash of $400,000, Marketable Securities of $200,000, Accounts Receivable of $600,000, Inventory of $1,000,000, and Current Liabilities of $800,000. What is Apex Corp's quick ratio?
- Identify quick assets: Cash ($400,000) + Marketable Securities ($200,000) + Accounts Receivable ($600,000) = $1,200,000.
- Exclude inventory ($1,000,000).
- Divide by Current Liabilities: $1,200,000 / $800,000 = 1.5.
A company with current assets of $5,000,000 (including $2,000,000 in inventory) and current liabilities of $2,500,000 pays off $500,000 of its accounts payable in cash. What is the immediate effect on its current ratio?