Activity, Liquidity, Solvency, and Profitability Ratios

Updated for the 2026-2027 CFA® Level I curriculum.

Financial ratios turn raw numbers from the balance sheet and income statement into measures you can compare across companies and time periods. CFA Level I sorts these ratios into four categories: activity, liquidity, solvency, and profitability. Each category answers a different question about a company's financial condition. The exam tests whether you can calculate the right ratio from the right inputs and explain what the result means.

Key Takeaways

• Activity ratios show how efficiently a company converts assets like inventory and receivables into sales and cash.

• Liquidity ratios show whether current assets can cover current liabilities in the short term.

• Solvency ratios show how much a company relies on debt and whether earnings cover fixed financial charges.

• Profitability ratios show how much profit a company earns relative to revenue, assets, or equity.

• Most ratios that pair an income statement figure with a balance sheet figure use average balance sheet values, not year-end values.

• A correct calculation with the wrong interpretation earns no credit. The exam tests both steps together.

What You Need to Know for CFA Level I

• The LOS verb is "calculate and interpret." You need the number and what it means for the company.

• This page owns the four principal ratio categories only: activity, liquidity, solvency, and profitability.

• Ratios that combine categories into a broader analytical story, such as DuPont decomposition, belong to a separate note on relationships among ratios.

• Most ratios that compare an income statement flow to a balance sheet stock use average balances (beginning plus ending, divided by two).

• A high or low ratio is never automatically good or bad. Judge it against industry norms and the company's own trend.

• The most common trap is misclassifying a ratio, such as treating a solvency ratio as a liquidity ratio because both involve obligations.

The Four Ratio Categories at a Glance

Each category uses different combinations of income statement and balance sheet inputs. Matching the correct numerator and denominator matters more than memorizing the category name.

Activity Ratios: Measuring Asset Efficiency

Activity ratios show how quickly a company turns assets like inventory and receivables into sales and cash.

where:

• COGS: Cost of goods sold during the reporting period.

• Revenue: Sales recognized during the reporting period.

• Average inventory: (Beginning inventory + Ending inventory) ÷ 2.

• Average receivables: (Beginning receivables + Ending receivables) ÷ 2.

• Average total assets: (Beginning total assets + Ending total assets) ÷ 2.

• Inventory turnover: Number of times average inventory is sold during the period.

• Receivables turnover: Number of times average receivables are collected during the period.

• DOH: Days of inventory on hand.

• DSO: Days of sales outstanding.

• 365: Assumed number of days in a year for DOH and DSO calculations.

Higher turnover generally indicates faster conversion of assets into sales or cash. Lower DOH or DSO indicates faster inventory movement or collection. Compare results with industry peers because normal turnover differs by business model.

Liquidity Ratios: Meeting Short-Term Obligations

Liquidity ratios test whether current assets can cover current liabilities within the next twelve months.

where:

• Current assets: Assets expected to be converted to cash, sold, or consumed within one year or the operating cycle, as applicable.

• Current liabilities: Obligations expected to be settled within one year or the operating cycle, as applicable.

• Cash: Cash and cash equivalents.

• Short-term investments: Readily marketable, liquid investments.

• Receivables: Amounts owed by customers.

• Quick ratio: Excludes inventory and prepaid items from current assets because they are less readily available to settle obligations.

• Cash ratio: Excludes receivables as well, focusing on cash, cash equivalents, and qualifying short-term investments.

• DOH: Days of inventory on hand.

• DSO: Days of sales outstanding.

• Days of payables: 365 ÷ Payables turnover.

• Payables turnover: Purchases ÷ Average trade payables.

• Cash conversion cycle: Net number of days cash is tied up in operating working capital.

A current ratio above 1.0 means current assets exceed current liabilities. An unusually high ratio can also indicate idle or slow-moving assets, so assess liquidity alongside asset quality and operating needs.

Solvency Ratios: Reliance on Debt and Capacity to Cover Obligations

Solvency ratios measure how much of a company's capital structure comes from debt and whether earnings comfortably cover fixed financial charges.

where:

• Total debt: Interest-bearing short-term and long-term borrowings.

• Total equity: Shareholders' equity reported on the balance sheet.

• EBIT: Earnings before interest and taxes.

• Interest expense: Financing cost incurred on borrowings during the period.

• Average total assets: (Beginning total assets + Ending total assets) ÷ 2.

• Average total equity: (Beginning total equity + Ending total equity) ÷ 2.

• Financial leverage: Compares average total assets with average total equity.

Debt-to-equity compares debt directly with equity, while financial leverage compares assets with equity. Interest coverage assesses the company's ability to meet interest costs using operating earnings.

Profitability Ratios: Converting Revenue Into Profit

Profitability ratios measure how much profit a company generates relative to revenue, assets, or equity.

where:

• Net income: Profit after expenses and taxes for the period.

• Revenue: Sales recognized during the period.

• Average total assets: (Beginning total assets + Ending total assets) ÷ 2.

• Average total equity: (Beginning total equity + Ending total equity) ÷ 2.

• ROA: Return on assets.

• ROE: Return on equity.

Net profit margin measures profit per dollar of sales. ROA measures profit relative to average assets, while ROE measures profit relative to average equity. Debt financing can increase ROE relative to ROA, but it also increases financial risk.

Working Example

Scenario: Carrow Supply Co. reports the following for the fiscal year:

• Revenue: $600,000

• Cost of goods sold: $360,000

• Average inventory: $60,000

• Current assets: $150,000

• Current liabilities: $100,000

• Total debt: $200,000

• Total equity: $250,000

• Net income: $54,000

Step 1: Activity ratio.

Step 2: Liquidity ratio.

Step 3: Solvency ratio.

Step 4: Profitability ratio.

Carrow turns over inventory about six times a year, holding it roughly 61 days before sale. It holds $1.50 of current assets for every $1 of current liabilities, a short-term asset-to-liability measure whose adequacy depends on asset quality and payment timing. It carries $0.80 of debt for every $1 of equity, a leverage measure that needs industry and trend comparison. It converts 9% of revenue into net income. None of these numbers is good or bad in isolation. An analyst would compare each against Carrow's prior years and against similar suppliers before drawing a conclusion.

Complete the Cash Conversion Cycle

For a separate company, annual credit sales are $730,000, COGS is $438,000, and purchases are $438,000. Average receivables are $100,000, average inventory is $90,000, and average trade payables are $60,000. Assume all relevant purchases are on credit and use 365 days.

Inventory is held for 75 days and customers take another 50 days to pay, while suppliers finance 50 days of the process. The net operating cash commitment lasts about 75 days.

Use purchases for payables turnover when available. COGS is a proxy when purchases are unavailable or reasonably similar; the two can differ when inventory changes.

A shorter cycle can release cash, but inspect the cause. Faster collection or lower obsolete inventory can improve operations. Delaying supplier payments beyond agreed terms can shorten the reported cycle while damaging supply relationships.

Common Exam Traps

Confusing turnover ratios with days ratios

Turnover measures how many times per year an event occurs. Days measures how long the cycle takes. Dividing 365 by the wrong turnover figure flips the result and the interpretation.

Treating debt-to-equity and financial leverage as identical

Debt-to-equity compares debt to equity. Financial leverage compares total assets to equity. Both are solvency measures, but they use different numerators and tell you different things about the capital structure.

Using year-end balances instead of averages

Many activity and profitability ratios pair an income statement flow with average balance sheet figures. Using only the year-end balance distorts the ratio, especially when the balance sheet account changed significantly during the year.

Assuming a higher current ratio is always better

A very high current ratio can mean the company is holding excess idle assets, such as slow-moving inventory, rather than managing liquidity well.

Mixing up quick ratio and cash ratio components

The quick ratio includes receivables. The cash ratio does not. Including receivables in a cash ratio calculation overstates the company's most conservative liquidity measure.

Practice Question

A company reports net income of $45 million, average total assets of $500 million, and average total equity of $300 million for the year. Which ratio category does return on equity belong to, and what is its value?

1. Solvency ratio; 15.0%

2. Profitability ratio; 15.0%

3. Profitability ratio; 9.0%

FAQs About Activity, Liquidity, Solvency, and Profitability Ratios