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 which 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.

Computation of Liquidity and Solvency Ratios

$$ \begin{array}{ccc} {} & {\textbf {Solvency ratios}\quad \quad \quad} & {} \\ \end{array} $$ $$ \begin{array}{|c|c|c|} \hline \text{Long term debt-to-equity} & { \cfrac {\text {Total long term debt}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \hline \text{Debt-to-equity} & {\cfrac {\text{Total debt}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \hline \text{Total debt} & {\cfrac {\text{Total debt}}{\text{Total assets}}} & \text{Financial leverage and financial risk} \\ \hline \text{Financial leverage} & {\cfrac {\text{Total assets}}{\text{Total equity}}} & \text{Financial leverage and financial risk} \\ \hline \end{array} $$

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

Question 1

The following balance sheet information is given for company XYZ.

Company XYZ balance sheet

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

Which of the following is the current ratio for company XYZ?

A. 0.67

B. 0.34

C. 1.20

Solution

The correct answer is A.

Current ratio = Current assets/Current liabilities = 2,557,034/3,825,396 = 0.67

Question 2

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

$$ \begin{array}{|c|c|c|c|} \hline \textbf{Assets} & \text{} & \textbf{Equities & Liabilities} & \text{} \\ \hline \text{Cash} & {50} & \text{Accounts payable} & {30} \\ \hline \text{Accounts Receivables} & {80} & \text{Long term liabilities} & {150} \\ \hline \text{Property,plant and} & {270} & \text{Shareholder’s equity} & {220} \\ \text{Equipment(PPE)} & {} & {} & {} \\ \hline \text{Total Assets} & {400} & \text{Total equities and} & {400} \\ {} & {} & \text{liabilities} & {} \\ \hline \end{array} $$

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

A. 3.67

B. 4.72

C. 4.33

Solution

The correct answer is C.

Current ratio = Current assets/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.

Current ratio = (Cash + Accounts receivable)/Accounts payable = (50 + 80)/30 = 4.33

 

Reading 22 LOS 22h:

Calculate and interpret liquidity and solvency ratios

 

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