Liquidity Ratios Quiz

Liquidity Ratios

• Current Ratio: Measures a company's ability to pay short-term obligations using its short-term assets. Calculated as Current Assets divided by Current Liabilities.

  • A higher ratio generally indicates better liquidity, suggesting the company is more likely to meet its short-term obligations.
  • A ratio below 1.0 is a cause for concern, as it suggests the company might struggle to meet its short-term liabilities with its current assets.

• Quick Ratio (Acid-Test Ratio): A more stringent measure of liquidity than the current ratio. Excludes inventory (a less liquid current asset) from current assets. Calculated as (Current Assets - Inventory) divided by Current Liabilities.

  • A higher ratio indicates better short-term solvency, suggesting a greater capacity to pay off immediate debts without relying on inventory.
  • A ratio below 1.0 suggests potential difficulty in meeting immediate obligations.

• Inventory Turnover Ratio: Measures how efficiently a company manages its inventory. Calculated as Cost of Goods Sold divided by Average Inventory.

  • A higher ratio indicates faster turnover and efficient inventory management. Inventory is being sold quickly and not tied up for a long time.
  • A slower turnover could signify issues like overstocking or slow-moving items.

Solvency Ratios

• Debt-to-Equity Ratio: Assesses the proportion of financing from debt versus equity. Calculated as Total Debt divided by Total Equity.

  • A higher ratio suggests higher leverage (more reliance on debt), increasing financial risk.
  • A lower ratio signifies lower reliance on debt, indicating a financially stronger position but potentially reduced growth opportunities.

• Debt-to-Assets Ratio: Shows the proportion of assets financed by debt. Calculated as Total Debt divided by Total Assets.

  • A higher ratio indicates higher financial risk. More of the company's assets are financed through debt.
  • A lower ratio signifies lower reliance on debt, indicating a safer financial position to a certain degree.

• Interest Coverage Ratio: Evaluates a company's ability to pay its interest expense. Calculated as Earnings Before Interest and Taxes (EBIT) divided by Interest Expense.

  • A higher ratio signifies better capacity to meet interest obligations.
  • A lower ratio raises concerns about the company's ability to pay interest without impacting its earnings.

• Return on Equity (ROE): Measures profitability for each rupee invested by shareholders. Calculated as Net Income divided by Total Equity.

  • A higher ROE indicates better profitability and efficient use of shareholder equity.
  • A lower ROE could signal issues in profitability or inefficient use of equity. This often correlates with solvency issues, as it shows how efficiently the firm utilizes the equity capital it has.

• Return on Assets (ROA): Measures how effectively a company uses its assets to generate profit. Calculated as Net Income divided by Total Assets.

  • A higher ROA indicates that the company is efficient in utilizing its assets to produce profits.
  • A lower ROA could reflect problems in managing assets effectively.