Study Tip #25: Some Tips for Studying Financial Ratios
|The BOK covers 18 financial ratios, grouped in 4 financial statement analysis categories. And any of them could show up as questions on your CTP exam. So, here’s a couple of tips on how to prepare to answer financial ratio questions.|
First memorize which ratios are included in each of the 4 categories. This might help you to recall which ratio must be used to answer a given exam question. And second, use flash cards to study the individual ratios in each category. These flash cards should show the ratio on one side and the opposite side should have a couple of short bullet points stating why this ratio is important or how is it used to make informed business decisions or what it tells the analyst about the financial situation of the company. By preparing these flash cards in this way you are preparing yourself to solve financial ratio calculation questions, as well as, answer conceptual questions regarding the financial ratios.
Additionally, here are some specific study points related to certain ratios:
Long –Term Debt to Capital
Because this ratio measures the relationship between LT Debt and the Total Capital position of the company (i.e. LT Debt + Equity), it provides the “weighting factors” used in the Weighted Average Cost of Capital (WACC) calculation. For example, if this ratio is 30% (i.e. LT Debt represents 30% of the company’s total capital position), then Equity represents 70% of the company’s total capital position. It’s possible that you could get a WACC calculation question that requires you to know how to calculate this ratio in order to get the LT Debt and Equity percentages to place into the WACC equation.
Current and Quick Ratios
If you get a question that addresses either one of these ratios, read the question very carefully to determine exactly which ratio you are being asked to calculate. It’s possible that since both these ratios are so similar, you could solve for the wrong one and still find that answer as one of the four multiple choices.
Return on Common Equity
Remember, if a company doesn’t have Preferred Shareholders, then the numerator “Earnings Available to Common Shareholders” is synonymous with Net Income.
Cash Flow to Total Debt
The numerator in this ratio is essentially restating Net Income to a cash flow basis by adding back in Non-Cash Items such as Depreciation and Amortization. This ratio as presented in the BOK shows only Depreciation being added to the Net Income. So, just to play it safe, I suggest that on your flash card for this ratio you show the numerator adding in Amortization also, like this:
[Net Income + ( Depreciation + Amortization)]
-George Schilling, CTP