{"id":4190,"date":"2019-03-06T23:29:28","date_gmt":"2019-03-06T23:29:28","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=4190"},"modified":"2026-01-23T09:59:18","modified_gmt":"2026-01-23T09:59:18","slug":"activity-liquidity-solvency-profitability-valuation-ratios","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/financial-reporting-and-analysis\/activity-liquidity-solvency-profitability-valuation-ratios\/","title":{"rendered":"Activity, Liquidity, Solvency, Profitability, and Valuation Ratios"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n  \"name\": \"Financial Analysis Techniques (2025 Level I CFA\u00ae Exam \u2013 Financial Reporting and Analysis \u2013 Module 6)\",\n  \"description\": \"This lesson covers Financial Analysis Techniques for the 2025 CFA\u00ae Level I Financial Reporting and Analysis curriculum. It introduces key tools and techniques used in financial analysis and explains their uses and limitations. The video walks through activity, liquidity, solvency, profitability, and valuation ratios, examines relationships among ratios, and demonstrates company evaluation using ratio analysis. It also applies DuPont analysis of return on equity, covers ratios used in equity and credit analysis, explains segment reporting requirements, and shows how ratio analysis and related techniques are used to model and forecast earnings.\",\n  \"uploadDate\": \"2022-04-15T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/img.youtube.com\/vi\/n-tgI2uEev4\/default.jpg\",\n  \"contentUrl\": \"https:\/\/youtu.be\/n-tgI2uEev4\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/n-tgI2uEev4\",\n  \"duration\": \"PT59M43S\"\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Company ABC\u2019s net profit margin is closest to:\",\n    \"text\": \"You have been provided with the following information on Company ABC for the year 2020:\\n\\nRevenue: $5,276,987;\\nGross profit: $3,534,099; and\\nNet income: $2,956,123.\\n\\nCompany ABC\u2019s net profit margin is closest to:\\nA. 56.02%\\nB. 66.97%\\nC. 83.64%\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is A. Net profit margin is calculated as net income divided by revenue. Using the given figures, net profit margin equals $2,956,123 divided by $5,276,987, which is approximately 56.02%.\"\n    }\n  }\n}\n<\/script>\n\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Which category of ratios evaluates a company\u2019s ability to pay back a bank loan?\",\n    \"text\": \"Which of the following categories of ratios could be used to evaluate a company\u2019s ability to pay back a bank loan?\\n\\nA. Liquidity ratios.\\nB. Solvency ratios.\\nC. Profitability ratios.\",\n    \"answerCount\": 3,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is B. Solvency ratios measure a company\u2019s ability to meet long-term obligations, including bank loans and bond obligations. Liquidity ratios focus on short-term obligations, while profitability ratios assess a firm\u2019s ability to generate profits from its assets.\"\n    }\n  }\n}\n<\/script>\n\n\n\n<iframe loading=\"lazy\"\n  width=\"611\"\n  height=\"344\"\n  src=\"https:\/\/www.youtube.com\/embed\/n-tgI2uEev4\"\n  title=\"YouTube video player\"\n  frameborder=\"0\"\n  allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\"\n  referrerpolicy=\"strict-origin-when-cross-origin\"\n  allowfullscreen>\n<\/iframe>\n\n\n\n<p>Financial ratios are used to express one financial quantity with reference to another. Financial ratios can assist with company and security valuations, as well as stock selections, and forecasting.<\/p>\n\n\n\n<p>A variety of categories may be used to classify financial ratios. Although the names of these categories and the ratios that are included in each of them can vary significantly, common categories that are used include activity, liquidity, solvency, profitability, and valuation ratios.&nbsp; Each category measures a different aspect of a company\u2019s business. However, all categories are important in the evaluation of a company\u2019s overall ability to generate cash flows from its business operations.<\/p>\n\n\n\n<h2 class=\"wp-block-heading\"><strong>Activity Ratios<\/strong><\/h2>\n\n\n\n<p>Activity ratios are also known as asset utilization ratios or operating efficiency ratios. They measure how efficiently a company performs its daily tasks such as managing its various assets. These ratios generally combine income statement information in the numerator and balance sheet information in the denominator.<\/p>\n\n\n\n<p>The list below describes the most commonly used activity ratios:<\/p>\n\n\n\n<div style=\"margin: 0 0 20px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      border: 2px solid #1e63ff;\n      color: #1e63ff;\n      background: #ffffff;\n      padding: 10px 14px;\n      border-radius: 10px;\n      font-weight: 500;\n      line-height: 1.35;\n      text-decoration: none;\n    \"\n  >\n    Want to apply financial ratios to real company analysis scenarios? Try AnalystPrep\u2019s free trial now.\n  <\/a>\n<\/div>\n\n\n<\/p>\n<ul>\n<li>\n<h3><strong>Inventory Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: cost of goods sold\/average inventory<\/p>\n<p>Interpretation: the ratio can be used to measure the effectiveness of inventory management. A higher inventory turnover ratio implies that inventory is held for a shorter time period.<\/p>\n<ul>\n<li>\n<h3><strong>Days of Inventory on Hand (DOH)<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: number of days in period\/inventory turnover<\/p>\n<p>Interpretation: the ratio can also be used to measure the effectiveness of inventory management. A lower DOH implies that inventory is held for a shorter time period.<\/p>\n<ul>\n<li>\n<h3><strong>Receivables Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: revenue\/average receivables<\/p>\n<p>Interpretation: this measures the efficiency of a company\u2019s credit and collection processes. A relatively high receivables turnover ratio may indicate that a company has highly efficient credit and collections. Similarly, it could imply that a company\u2019s credit or collection policies are too stringent.<\/p>\n<ul>\n<li>\n<h3><strong>Days of Sales Outstanding (DSO)<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: number of days in period\/receivables turnover<\/p>\n<p>Interpretation: this measures the time that elapses between a sale and cash collection. It reflects how fast a company collects cash from customers to whom it extends credit. A low DSO indicates that a company is efficient in its credit and collection processes.<\/p>\n<ul>\n<li>\n<h3><strong>Payables Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: purchases\/average trade payables<\/p>\n<p>Interpretation: this measures the number of times per year that a company theoretically pays off all its creditors.<\/p>\n<ul>\n<li>\n<h3><strong>Number of Days of Payables<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: number of days in period\/payables turnover<\/p>\n<p>Interpretation: this reflects the average number of days that a company takes to pay its suppliers.<\/p>\n<ul>\n<li>\n<h3><strong>Working Capital Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: revenue\/average working capital<\/p>\n<p>Interpretation: this indicates how efficiently a company generates revenue with its working capital. A high working capital turnover ratio indicates greater efficiency.<\/p>\n<ul>\n<li>\n<h3><strong>Fixed Asset Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: revenue\/average net fixed assets<\/p>\n<p>Interpretation: this measures how efficiently a company generates revenues from its investments in fixed assets. A higher fixed asset turnover ratio indicates a more efficient use of fixed assets in generating revenue.<\/p>\n<ul>\n<li>\n<h3><strong>Total Asset Turnover<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: revenue\/average total assets<\/p>\n<p>Interpretation: this measures a company\u2019s overall ability to generate revenues with a given level of assets. A low asset turnover ratio can be an indication of inefficiency or the relative capital intensity of the company.<\/p>\n<h2><strong>Liquidity Ratios<\/strong><\/h2>\n<p>Liquidity ratios measure a company\u2019s ability to satisfy its short-term obligations. These ratios reflect a company\u2019s position at a point in time. They, therefore, usually use ending balance sheet data rather than averages. The list below describes the most commonly used liquidity ratios.<\/p>\n<ul>\n<li>\n<h3><strong>Current Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: current assets\/current liabilities<\/p>\n<p>Interpretation: a higher current ratio indicates a higher level of liquidity or ability to meet short-term obligations.<\/p>\n<ul>\n<li>\n<h3><strong>Quick Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: (cash + short-term marketable investments + receivables)\/current liabilities<\/p>\n<p>Interpretation: a higher quick ratio indicates a higher level of liquidity or ability to meet short-term obligations. It is a better indicator of liquidity than the current ratio in instances where inventory is illiquid.<\/p>\n<ul>\n<li>\n<h3><strong>Cash Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: (cash + short-term marketable investments)\/current liabilities<\/p>\n<p>Interpretation: the ratio is a reliable measure of liquidity in a crisis.<\/p>\n<ul>\n<li>\n<h3><strong>Defensive Interval Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: (cash + short-term marketable investments + receivables)\/daily cash expenditures<\/p>\n<p>Interpretation: this measures how long a company can pay its daily expenditures using only its existing liquid assets, without any additional cash inflow.<\/p>\n<ul>\n<li>\n<h3><strong>Other Ratios<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>In addition to the above ratios, the cash conversion cycle is an additional liquidity measure that can be used. Computed as DOH + DSO \u2013 Number of days of payables, it measures the length of time that is required for a company to go from cash paid (used in operations) to cash received (as a result of operations).<\/p>\n<h2><strong>Solvency Ratios<\/strong><\/h2>\n<p>Solvency ratios measure a company\u2019s ability to satisfy its long-term obligations. They provide information relating to the relative amount of debt in a company\u2019s capital structure. Moreover,they reveal the adequacy of a company&#8217;s earnings and cash flow to cover interest expenses and other fixed charges as they fall due.<\/p>\n<p>There are two types of solvency ratios: (i) debt ratios, which focus on the balance sheet and measure the amount of debt capital relative to equity capital; and (ii) coverage ratios, which focus on the income statement and measure the ability of a company to cover its debt payments. Both sets of ratios are useful in assessing a company\u2019s solvency and evaluating the quality of its bonds and other debt obligations.<\/p>\n<p>Below is a list of the most commonly used solvency ratios:<\/p>\n<ul>\n<li>\n<h3><strong>Debt-to-Assets Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: total debt\/total assets<\/p>\n<p>Interpretation: this measures the percentage of a company\u2019s total assets that are financed with debt. A higher ratio implies higher financial risk and weaker solvency.<\/p>\n<ul>\n<li>\n<h3><strong>Debt-to-Capital Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: total debt\/(total debt + total shareholders\u2019 equity)<\/p>\n<p>Interpretation: this measures the percentage of a company\u2019s capital (debt + equity) that is represented by debt. A higher ratio implies higher financial risk and weaker solvency.<\/p>\n<ul>\n<li>\n<h3><strong>Debt-to-Equity Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: total debt\/total shareholders\u2019 equity<\/p>\n<p>Interpretation: this measures the amount of debt capital relative to equity capital. A higher ratio implies higher financial risk and weaker solvency.<\/p>\n<ul>\n<li>\n<h3><strong>Financial Leverage Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: average total assets\/average total equity<\/p>\n<p>Interpretation: this measures the number of total assets that are supported for each one money unit of equity. The higher the ratio, the more leveraged the company in its use of debt and other liabilities to finance assets.<\/p>\n<ul>\n<li>\n<h3><strong>Interest Coverage Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: EBIT\/interest payments<\/p>\n<p>Interpretation: this measures the number of times that a company\u2019s EBIT could cover its interest payments. A higher ratio indicates stronger solvency.<\/p>\n<ul>\n<li>\n<h3><strong>Fixed-charge Coverage Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: (EBIT + lease payments)\/(interest payments + lease payments)<\/p>\n<p>Interpretation: this measures the number of times a company\u2019s earnings (before interest, taxes, and lease payments) can cover its interest and lease payments. A higher ratio indicates stronger solvency.<\/p>\n<h2><strong>Profitability Ratios<\/strong><\/h2>\n<p>Profitability ratios measure a company\u2019s ability to generate profits from its resources (assets). There are two types of profitability ratios: (i) return-on-sales profitability ratios, which express various sub-totals on the income statement as a percentage of revenue, and(ii) return-on-investment profitability ratios, which measure income relative to the assets, equity, or total capital employed by a company.<\/p>\n<p>The list below describes the most commonly used solvency ratios:<\/p>\n<ul>\n<li>\n<h3><strong>Gross Profit Margin<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: gross profit\/revenue<\/p>\n<p>Interpretation: this indicates the percentage of revenue that is available to cover operating and other expenses and to generate profit. A higher gross profit margin indicates a combination of higher product pricing and lower product costs.<\/p>\n<ul>\n<li>\n<h3><strong>Operating Profit Margin<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: operating income\/revenue<\/p>\n<p>Interpretation: an operating profit margin that increases faster than the gross profit margin can indicate improvements in controlling operating costs, such as administrative overheads.<\/p>\n<ul>\n<li>\n<h3><strong>Pretax Margin<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: EBT (earnings before tax but after interest)\/revenue<\/p>\n<p>Interpretation: this reflects the effect on the profitability of leverage and other non-operating income and expenses.<\/p>\n<ul>\n<li>\n<h3><strong>Net Profit Margin<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: net income\/revenue<\/p>\n<p>Interpretation: this measures how much of each dollar collected as revenue translates into profit.<\/p>\n<ul>\n<li>\n<h3><strong>Operating ROA<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: operating income\/average total assets<\/p>\n<p>Interpretation: this measures the return (before deducting interest on debt capital) that is earned by a company on its assets.<\/p>\n<ul>\n<li>\n<h3><strong>Return on Assets (ROA)<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: net income\/average total assets<\/p>\n<p>Interpretation: this measures the return earned by a company on its assets.<\/p>\n<ul>\n<li>\n<h3><strong>Return on Total Capital<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: EBIT\/Short- and long-term debt and equity<\/p>\n<p>Interpretation: this measures the profits that a company earns on all of the capital that it employs.<\/p>\n<ul>\n<li>\n<h3><strong>Return on Equity (ROE)<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: net income\/average total equity<\/p>\n<p>Interpretation: this measures the return earned by a company on its equity capital, including minority equity, preferred equity, and common equity.<\/p>\n<ul>\n<li>\n<h3><strong>Return on Common Equity<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: (net income \u2013 preferred dividends)\/average common equity<\/p>\n<p>Interpretation: this measures the return earned by a company only on its common equity.<\/p>\n<h2><strong>Valuation Ratios<\/strong><\/h2>\n<p>Valuation ratios measure the quantity of an asset or flow that is associated with the ownership of a specified claim.<\/p>\n<p>The list below provides a list and description of the most commonly used valuation ratios:<\/p>\n<ul>\n<li>\n<h3><strong>Price to Earnings or P\/E Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: price per share\/earnings per share<\/p>\n<p>Interpretation: this tells how much an investor in common stock pays per dollar of earnings.<\/p>\n<ul>\n<li>\n<h3><strong>Price to Cash Flow or P\/CF Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: price per share\/cash flow per share<\/p>\n<p>Interpretation: this measures a company\u2019s market value relative to its cash flow.<\/p>\n<ul>\n<li>\n<h3><strong>Price to Sales or P\/S Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: price per share\/sales per share<\/p>\n<p>Interpretation: this compares a company\u2019s stock price to its revenue. It is sometimes used as a comparative price metric when a company does not have a positive net income.<\/p>\n<ul>\n<li>\n<h3><strong>Price to Book Value or P\/BV Ratio<\/strong><\/h3>\n<\/li>\n<\/ul>\n<p>Computation: price per share\/book value per share<\/p>\n<p>Interpretation: this compares a stock\u2019s market value to its book value. It is often used as an indicator of market judgment about the relationship between a company\u2019s required rate of return and its actual rate of return. A higher ratio implies that investors expect management to create more value from a given set of assets, all else equal.<\/p>\n<blockquote>\n<h3><strong>Question 1<\/strong><\/h3>\n<p>You have been provided with the following information on Company ABC for the year 2020:<\/p>\n<p>Revenue: $5,276,987;<\/p>\n<p>Gross profit: $3,534,099; and<\/p>\n<p>Net income: $2,956,123.<\/p>\n<p>Company ABC\u2019s net profit margin is <em>closest to<\/em>:<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li data-tadv-p=\"keep\">56.02%.<\/li>\n<li data-tadv-p=\"keep\">66.97%<\/li>\n<li data-tadv-p=\"keep\">83.64%<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is <strong>A<\/strong>.<\/p>\n<p>Net profit margin = Net income\/revenue = $2,956,123\/$5,276,987= 56.02%<\/p>\n<h3><strong>Question 2<\/strong><\/h3>\n<p>Which of the following categories of ratios could be used to evaluate a company\u2019s ability to pay back a bank loan?<\/p>\n<ol style=\"list-style-type: upper-alpha;\">\n<li data-tadv-p=\"keep\">Liquidity ratios.<\/li>\n<li data-tadv-p=\"keep\">Solvency ratios.<\/li>\n<li data-tadv-p=\"keep\">Profitability ratios.<\/li>\n<\/ol>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is <strong>B<\/strong>.<\/p>\n<p>Solvency ratios measure a company\u2019s ability to meet long-term obligations such as bank loans and bond obligations.<\/p>\n<p><strong>A is incorrect.<\/strong> Liquidity ratios measure a company\u2019s ability to satisfy its short-term obligations.<\/p>\n<p><strong>C is incorrect.<\/strong> Profitability ratios measure a company\u2019s ability to generate profits from its resources (assets).<\/p>\n<\/blockquote>\n\n\n<div style=\"text-align: center; margin: 32px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      background-color: #1e63ff;\n      color: #ffffff;\n      padding: 12px 26px;\n      border-radius: 12px;\n      font-weight: 600;\n      font-size: 16px;\n      text-decoration: none;\n    \"\n  >\n    Start Free Trial \u2192\n  <\/a>\n\n  <div style=\"margin-top: 10px; font-size: 14px; color: #374151;\">\n    Practice activity, liquidity, solvency, profitability, and valuation ratio analysis using full CFA\u00ae-style company case questions.\n  <\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"<p>Financial ratios are used to express one financial quantity with reference to another. Financial ratios can assist with company and security valuations, as well as stock selections, and forecasting. A variety of categories may be used to classify financial ratios&#8230;.<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[5],"tags":[],"class_list":["post-4190","post","type-post","status-publish","format-standard","hentry","category-financial-reporting-and-analysis","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Activity, Liquidity, Solvency &amp; Profitability Ratios<\/title>\n<meta name=\"description\" content=\"Explore key financial ratios, including activity, liquidity, solvency, and profitability measures, to assess company performance and aid in valuations.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" 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