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Calculate and Interpret Liquidity and Solvency Ratios

Calculate and Interpret Liquidity and Solvency Ratios

Ratio analysis can assist with the conduct of time-series and cross-sectional analysis of a company’s financial position.

Balance sheet ratios are those ratios that involve balance sheet items only and include (i) liquidity ratios, which measure a company’s ability to meet short-term obligations; and (ii) solvency ratios, which measure financial risk, financial leverage, and a company’s ability to satisfy its long-term and other obligations.

Liquidity Ratios

$$ \begin{array}{c|c|c} \textbf{Ratio Name} & \textbf{Calculation} & \textbf{Indication} \\ \hline \text{Current Ratio} & {\cfrac {\text{Current assets}}{\text{Current liabilities}}} & \text{A company’s ability to meet} \\ {} & {} & \text{its short term obligations} \\ \hline \text{Quick Ratio (Acid test)} & {\text{Cash + Marketable securities}} & \text{Satisfies the same purpose as} \\ {} & {\cfrac {\text{+Receivables} }{\text{Current liabilities}} } & \text{the current ratio, but it’s} \\ {} & {} & \text{considered a tougher measure} \\ {} & {} & \text{as inventory is excluded } \\ \hline \text{Cash Ratio} & {\cfrac {\text{Cash + Marketable securities}}{\text{Current liabilities}}} & \text{Tests a company’s ability to} \\ {} & {} & \text{meet its short term} \\ {} & {} & \text{obligations using extremely} \\ {} & {} & \text{liquid assets} \\ \end{array} $$

Solvency Ratios

$$ \begin{array}{c|c|c} \textbf{Ratio Name} & \textbf{Calculation} & \textbf{Indication} \\ \hline \text{Long term debt-to-equity} & { \cfrac {\text {Total long term debt}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \hline \text{Debt-to-equity} & {\cfrac {\text{Total debt}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \hline \text{Total debt} & {\cfrac {\text{Total debt}}{\text{Total assets}}} & \text{Financial leverage and financial risk} \\ \hline \text{Financial leverage} & {\cfrac {\text{Total assets}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \end{array} $$

Question 1

The following balance sheet information is given for company XYZ.

$$ \textbf{Company XYZ Balance Sheet} $$

$$ \begin{array}{l|r} \textbf{Assets} & \bf {\text{Dec }31,2016 ($)} \\ \hline \text{Current Assets} & {} \\ \hline {\quad \quad \text{Cash and cash equivalents}} & {100,000} \\ \hline {\quad \quad \text{Short-term marketable securities}} & {1,234,678} \\ \hline {\quad \quad \text{Accounts receivable}} & {52,000} \\ \hline {\quad \quad \text{Inventory}} & {1,170,356} \\ \hline \text{Total current assets} & {2,557,034} \\ \hline \text{Property, plant, and equipment (PPE)} & {6,834,190} \\ \hline \text{Intangible assets} & {3,370,041} \\ \hline \textbf{Total assets} & \bf{12,761,265} \\ \hline \textbf{Liabilities and shareholders’ equity} & {} \\ \hline \text{Current Liabilities} & {} \\ \hline {\quad \quad \text{Accounts payable}} & {3,825,396} \\ \hline \text{Total current liabilities} & {3,825,396} \\ \hline \text{Bonds payable} & {3,771,894} \\ \hline \text{Total liabilities} & {7,597,290} \\ \hline \text{Total shareholders’ equity} & {5,163,975} \\ \hline \textbf{Total liabilities and shareholders’ equity} & \bf {12,761,265} \\ \end{array} $$

The current ratio for company XYZ is closest to:

  1. 0.34.
  2. 0.67.
  3. 1.20.

Solution

The correct answer is B.

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}} = \frac{2,557,034}{3,825,396} = 0.67$$

Question 2

Kylee Co. reported the following information on its latest balance sheet.

$$ \textbf{Kylee Co. Balance Sheet} $$

$$ \begin{array}{l|r|l|r} \textbf{Assets} & \text{} & \textbf{Liabilities & equity} & \text{} \\ \hline \text{Cash} & {50} & \text{Accounts payable} & {30} \\ \hline \text{Accounts receivables} & {80} & \text{Long-term liabilities} & {150} \\ \hline \text{Property, plant and} & {270} & \text{Shareholder’s equity} & {220} \\ \text{equipment (PPE)} & {} & {} & {} \\ \hline \textbf{Total assets} & {400} & \textbf{Total liabilities &} & {400} \\ {} & {} & \textbf{equity} & {} \\ \end{array} $$

According to the information provided, the current ratio of Kylee Co. is closest to:

  1. 3.67.
  2. 4.33.
  3. 4.72.

Solution

The correct answer is B.

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$$

The only current assets reported on the balance sheets are cash and accounts receivables. The only current liability reported above is accounts payable.

$$\text{Current ratio} = \frac{\text{(Cash + Accounts receivable)}}{\text{Accounts payable}} =\frac{(50 + 80)}{30 }= 4.33$$

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