Liquidity, Solvency, and Leverage Ratios Flashcards
What is liquidity?
a firm’s ability to pay its current obligations as they come due and remain in business in the short run
reflects the ease with which assets can be converted to cash
What is the descending order of liquidity for current assets?
- cash and cash equivalents
- marketable securities
- receivables (net of allowance for credit losses)
- inventories
- prepaid items
What does a low current ratio indicate
a possible solvency problem
care should be taken when determining whether to extend credit to a firm with a low ratio
What is solvency
the ability of a business to meet its long-term obligations
creditors prefer the total debt to total capital ratio to be ______
low
what does a low long-term debt to equity ratio mean
a firm will have an easier time raising new debt
What does a high operating leverage indicate
the firm necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales
the firm is able to expand production rapidly in times of higher product demand.
the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume
what does a high financial leverage indicate?
a firm necessarily carries a greater degree of risk because debt must be serviced regardless of the level of earnings.
if the firm is profitable, there is more residual profit for the shareholders after debt service, producing higher earnings per share
debt financing permits the current equity holders to retain control
The use of debt in the capital structure of a firm
increases its financial leverage
Financial leverage is the use of fixed costs in a firm’s capital structure, indicated by high interest payments on debt. These increased fixed costs (and accompanying lowered variable costs) make profitable periods more profitable and unprofitable periods worse.
An entity has total assets of $7,500,000 and a current ratio of 2.3 times before purchasing $750,000 of merchandise on credit for resale. After this purchase, the current ratio will
Be lower than 2.3 times.
The current ratio is the ratio of current assets to current liabilities. When the ratio is greater than one, any change of equal dollar amount on both the numerator and denominator will result in a lowering of the overall ratio (since the denominator will increase by a proportionally greater amount). The purchase of merchandise on credit is an example of such a change: Inventory increases in the numerator and accounts payable increases in the denominator by an equal dollar amount.
For a firm with a degree of operating leverage of 3.5, an increase in sales of 6% will
A degree of operating leverage (DOL) of 3.5 means that operating income (EBIT) will increase 3.5 times greater than any sales increase. Multiplying 3.5 times the 6% sales increase results in a pre-tax profit increase of 21%.
If a current ratio is less than 1.0, what improves the ratio?
a transaction that results in equal increases in the numerator and denominator
