Investment Theory and Portfolio Development - Ratio analysis: Liquidity Ratios
Candidates are expected to be able to compute the basic types of financial ratios and interpret them, so as to be able to gain a better understanding of a company's financial position. Current financial accounting pronouncements, the nuances of generally accepted accounting principles, as well as exercises requiring candidates to make adjustments to financial statements are not considered for the purpose of the CFP® exam.
- Liquidity Ratios - measure the ability of a company to meet its current financial commitments.
- Working Capital: the amount of liquid assets available to pay for near-term obligations. Not a ratio, its formula reads thus:
|Working Capital = current assets-current liabilities.|
- Current Ratio: compares current assets to current obligations and is calculated as follows:
|Current Ratio = Current assets/current liabilities|
- Acid-test (quick) ratio - a more extreme measure of a company's short-term liquidity, it measures 'quick' assets (current assets-inventory (less liquid)) as a percentage of current liabilities:
|Quick Ratio = Quick assets (current assets-inventory)/current liabilities.|
- Cash Assets Ratio - more stringent a measure, still, of a company's near-term liquidity, this ratio is calculated as follows:
|Cash Assets Ratio = Cash and Equivalents/Current Liabilities.|
- Debt Service Ratio:
|Debt Service Ratio = EBIT (Earnings Before Interest and Taxes)/Annual interest and principal payments|
Ratio Analysis: Activity, Profitability and Debt Ratios