Liquidity, Solvency, and Leverage Ratios

Question 1

What is liquidity?

Answer 1

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

Question 2

What is the descending order of liquidity for current assets?

Answer 2

• cash and cash equivalents
• marketable securities
• receivables (net of allowance for credit losses)
• inventories
• prepaid items

Question 3

What does a low current ratio indicate

Answer 3

a possible solvency problem

care should be taken when determining whether to extend credit to a firm with a low ratio

Question 4

What is solvency

Answer 4

the ability of a business to meet its long-term obligations

Question 5

creditors prefer the total debt to total capital ratio to be ______

Answer 5

low

Question 6

what does a low long-term debt to equity ratio mean

Answer 6

a firm will have an easier time raising new debt

Question 7

What does a high operating leverage indicate

Answer 7

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

Question 8

what does a high financial leverage indicate?

Answer 8

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