Financial Ratios

Financial Ratios

Financial ratios let an adviser size up a company quickly — its ability to pay short-term debts, how aggressively it uses leverage, how efficiently it turns sales into profit, and how the market values its earnings. The Series 66 doesn't ask you to memorize every formula or crank through long calculations. It asks you to interpret ratios in context — against a company's own history, against peers in the same industry, and in combination with other ratios that tell you whether the headline number is real or an artifact of leverage.

Why ratios matter

Financial ratios are the adviser's shorthand for a company's financial health. They reduce a balance sheet and income statement to a handful of numbers that can be compared — across time, across companies, across industries. The Series 66 doesn't reward students who can compute every ratio fastest; it rewards students who know which ratio answers a particular question and what its limits are.

Two themes run through this chapter. First, no single ratio tells the whole story — a strong current ratio can mask inefficient cash management; a high ROE can be the product of dangerous leverage. Second, ratios only acquire meaning in context — against the company's own history (trend analysis), against direct competitors (peer comparison), or against industry norms (sector benchmarks). A ratio in isolation is just a number.

The five categories of financial ratios

Financial ratios cluster into five families. Each answers a different question about the company.

Valuation ratios get full treatment in the next chapter (Valuation Factors); this chapter focuses on the first four families, with a brief preview of valuation at the end.

Current and quick ratios

Liquidity ratios measure a company's ability to meet obligations due within the next year. The two most-tested are the current ratio and the quick ratio.

• Above 1.0 means the company has more short-term assets than short-term obligations.
• Higher is generally better, but extremely high ratios may indicate inefficient use of cash and inventory (idle assets that could be deployed productively).
• A useful rule of thumb: between 1.5 and 3.0 is typically healthy for most industries.

The quick ratio (also called the acid-test ratio) is the stricter version. It excludes inventory because inventory may not convert quickly to cash, or may need to be sold at a discount in a pinch. The quick ratio tests whether the company can pay short-term debts without relying on selling inventory.

Working capital — the dollar version

Working capital is the absolute-dollar cousin of the current ratio. Instead of expressing the relationship as a ratio, it expresses the difference directly:

A company with $800K in current assets and $400K in current liabilities has $400K of working capital — the cushion available to fund day-to-day operations after paying the next year's bills. Positive working capital is the usual healthy state; negative working capital means short-term liabilities exceed short-term assets, which can be a yellow flag for liquidity stress.

Negative working capital isn't automatically fatal — some businesses (notably retailers like Walmart, who collect from customers fast and pay suppliers slowly) operate intentionally with negative working capital. But for most companies it warrants further investigation.

Current vs. quick ratio — side by side

Debt-to-equity ratio

Debt-to-equity is the most-tested leverage ratio on the Series 66. It measures how much of a company's financing comes from debt vs. owners' equity.

• D/E = 1.0 — equal amounts of debt and equity financing.
• D/E = 2.0 — $2 of debt for every $1 of equity (highly leveraged in most industries).
• D/E < 1.0 — the company is more equity-financed than debt-financed.

Higher leverage means greater financial risk — fixed interest payments must be made regardless of how earnings perform, so highly levered companies are more vulnerable to downturns. Higher leverage also magnifies returns to equity when things go well, which is why management teams often prefer some debt in the capital structure. The challenge is knowing what level of leverage is appropriate, which depends entirely on the industry.

Times-interest-earned (TIE) — coverage

Debt-to-equity tells you how much debt the company has. Times-interest-earned tells you whether the company can comfortably service that debt:

Where EBIT (earnings before interest and taxes, also called operating income) represents the company's earnings available to pay interest. The ratio expresses how many times over the company's operating earnings could cover its annual interest bill.

• TIE > 4.0 — comfortable coverage; minimal default risk from interest payments.
• TIE between 1.5 and 3.0 — adequate but watch closely; a downturn could squeeze coverage.
• TIE < 1.0 — operating earnings aren't even covering interest. The company is paying its lenders out of cash reserves or new borrowing, which isn't sustainable.

TIE is the single most important ratio for assessing whether a company's bonds are likely to default. It comes back in Module 2's fixed-income chapters as the primary credit-quality screen.

Leverage in context — industry norms vary widely

A debt-to-equity ratio of 2.0 means very different things depending on what business you're in:

Exam takeaway: when a Series 66 question describes a company's leverage, look for industry cues. A utility with D/E of 2.5 is unremarkable. A tech firm with D/E of 2.5 is a red flag. Same number, opposite reading.

Net margin, ROA, and ROE

Profitability ratios measure how effectively a company converts its inputs — sales, assets, equity — into bottom-line profit. The three most-tested are net profit margin, return on assets, and return on equity.

• Net profit margin = Net income ÷ Revenue. What percentage of every sales dollar ends up as profit. A 5% margin means 5 cents of profit per dollar of revenue. Margins vary enormously by industry — grocers operate on 1-3% margins; software companies often 20%+.
• Return on Assets (ROA) = Net income ÷ Total assets. How much profit the company generates per dollar of assets deployed. Measures pure operating efficiency, independent of how the assets are financed.
• Return on Equity (ROE) = Net income ÷ Shareholders' equity. How much profit the company generates per dollar of equity capital. ROE is what shareholders ultimately care about, but it's distorted by leverage — heavy borrowing mechanically inflates ROE without improving operating efficiency.

The relationship to lock in: ROE = ROA × (Total assets ÷ Equity). The right-hand term is the equity multiplier (a function of leverage). Two companies with identical ROA will report very different ROEs if one is far more leveraged. That's why the next block's leverage trap exists.

Earnings per share (EPS)

EPS is profitability expressed on a per-share basis — the headline number that drives equity valuation:

Diluted EPS uses a larger denominator that includes shares that could be issued if outstanding stock options, warrants, or convertible securities were exercised. Diluted EPS is always less than or equal to basic EPS — never higher. Most analysis uses diluted EPS as the more conservative number.

EPS is the building block of the price-to-earnings ratio in Section 5. A company can grow EPS in three ways: by growing net income, by reducing share count through buybacks, or both. Buyback-driven EPS growth without underlying income growth is a Series 66 trap — the per-share number rises while the business itself isn't more profitable.

Profitability ratios — side by side

Valuation ratios — what the market thinks

Valuation ratios compare a company's stock price to its underlying fundamentals. They tell you what the market is willing to pay for a dollar of earnings, a dollar of book value, or a dollar of dividends. Three to know:

P/E measures the price the market is paying per dollar of annual earnings. A P/E of 20 means investors are paying $20 today for each $1 of current earnings — effectively a 20-year payback period if earnings stay flat. Higher P/Es typically reflect higher growth expectations. Be careful comparing across industries: tech P/Es of 30+ are normal; utility P/Es of 15 are normal; these aren't apples-to-apples.

P/B compares market price to accounting net worth (assets minus liabilities, per share). A P/B above 1.0 means the market values the company above its book value — usually because intangibles, brand, and future earnings aren't reflected on the balance sheet. P/B is more useful for asset-heavy businesses (banks, REITs) than for intangible-heavy ones (software, brands).

Dividend yield expresses the dividend as a percentage of the stock price — effectively the cash income return. A stock trading at $40 paying $1.60 annual dividends has a 4% yield. The next chapter (Valuation Factors) develops these ratios further; this is the orientation pass.

How analysts actually use ratios

A single ratio in isolation is close to useless. Analysts combine three lenses:

1. Trend analysis — how has this company's ratio changed over the last 3-5 years? A current ratio drifting from 2.5 to 1.5 to 0.9 tells a story even if the current value is still acceptable.
2. Peer comparison — how does this company stack up against direct competitors in the same industry? Coca-Cola's ratios vs. Pepsi's. Citigroup's vs. JPMorgan's.
3. Industry benchmarks — how does the company compare to the typical company in its sector? Industry medians from data providers (S&P, Bloomberg, FactSet) give a reference point.

The Series 66 frequently tests this by presenting a ratio (or a small change in one) and asking what the adviser should do next. The right answer is almost never "buy" or "sell" based on the single data point — it's some version of "investigate further, compare to peers, look at trend." A ratio is a question, not an answer.

Worked example · ABC Corp ratio analysis

ABC Corp simplified financials: Current assets $800,000 (including $300,000 inventory) · Current liabilities $400,000 · Total liabilities $1,200,000 · Shareholders' equity $600,000 · Net income $120,000 · EBIT $200,000 · Interest expense $50,000.