Liquidity, Solvency and Profitability Flashcards
Liquidity: What is meant by the liquidity of a company? What does liquidity ratios measure?
The company’s ability to pay obligations that are expected to become due within the next year.
Liquidity ratios measure a company’s short-term ability to pay its maturing obligations and to meet unexpected needs for cash.
Liquidity: Working capital and current ratio are just two of other liquidity measures, explain both.
Working capital is the difference between current assets and current liabilities. When working capital is positive, there is a greater likelihood that the company will be able to pay its liabilities. When negative, a company may have to borrow money; otherwise, short-term creditors may not be paid. A higher amount indicates liquidity.
Current ratio is an important liquidity ratio which is calculated by dividing current assets by current liabilities. The current ratio is a more dependable indicator of liquidity than working capital. Two companies with the same amount of working capital may have significantly different current ratios. Current ratio means for every dollar of current liabilities there is ___ of current assets. For example: if a company’s results is .9, it is written as 0.9:1 - the 1 after the colon is the “for every dollar of current liabilities” and the 0.9 is the answer. A higher ratio suggests favourable liquidity.
Liquidity:
What is current ratio?
Which is favourable, high or low current ratio?
What does it mean if a company has to sell off fixed assets to pay for its current liabilities?
The current ratio is only one measure of liquidity. It does not take into account the composition of the current assets. Explain?
The current ratio helps investors and creditors understand the liquidity of a company and how easily the company will be able to pay off its current liabilities.
A higher current ratio is always more favourable than a lower current ratio because it shows the company can more easily make current debt payments.
If a company has to sell off fixed assets to pay for its current liabilities, this usually means the company isn’t making enough from operations to support activities. In other words,the company is losing money. Sometimes this is the result of poor collections of accounts receivable.
A satisfactory current ratio does not reveal that a portion of the current assets may be tied up in uncollectible accounts receivable or slow-moving inventory. The composition of the assets matters because a dollar of cash is more easily available to pay the bills than is a dollar of inventory. For example, suppose a company’s cash balance declined while its inventory increased significantly. If inventory increased because the company was having difficulty selling it, then the current ratio would not fully reflect the reduction in the company’s liquidity.
Liquidity: what does the quick ratio a.k.a acid test ratio measure? What are quick assets? What is the formula for quick ratio?
Measures the ability of a company to pay its current liabilities when they come due with only quick assets.
Quick assets are current assets that can be converted to cash within 90 days or in the short term. Cash, cash equivalents, short term investments or marketable securities, and current accounts receivable are considered quick assets.
Formula:
Quick ratio = cash + cash equivalents + short term investments + current receivables / current liabilities
Higher is better. For every $1 of current liabilities, there are $___ if current assets.
Solvency: What are solvency ratios? Who are interested in a company’s long-run solvency.
Solvency ratios measure a company’s ability to survive over a long period of time. Investors and long-term lenders are interested in a company’s long-run solvency- it’s ability to pay interest as it comes due and to repay the face value of debt at maturity.
Solvency: What is Debt to Total Assets and how is it calculated? Why is financing provided by lenders and creditors more riskier?
The debt to total assets ratio is about a company’s long-term debt-paying ability. It measures the percentage of assets that is financed by lenders and other creditors rather than by shareholders. This is calculated by dividing total debt (both current and non-current liabilities) by total assets. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to pay its debts as they come due. A lower percentage suggests favourable solvency.
Financing provided by lenders and creditors (debt) is riskier than financing provided by shareholders (equity) because debt must be repaid at specific points in time, whether the company is performing well or not. Equity does not have to be repaid.
Profitability: Existing and potential investors, lenders, and other creditors are interested in a company’s profitability. What are Profitability Ratios?
Profitability ratios measure a company’s operating success for a specific period of time. Two examples of profitability ratios are earnings per share and price-earning ratio.
Profitability: What are Earnings Per Share (EPS) ratio?
EPS measures the profit earned on each common share. Accordingly, earnings per share is reported only for common shareholders. It is calculated by dividing the profit available to the common shareholders by the weighted average number of common shares. A higher measure suggests improved performance. Values should not be compared across companies.
Example:
90,000/90,000= $1.00 earnings per share, $12/$1 = 12 times price-earnings ratio
40,000/50,000 = $0.80 earnings per share , $8/$0.80 = 10 times price-earning ratio
Unless a company has preferred shares, the profit available to common shareholders will be the same as the profit reported on a company’s income statement. If a company has preferred shares, preferred share dividends must be deducted from profit.
Profitability: Why should reducing profit to a per-share amount useful for shareholders to determine investment return? ~
How important is earnings per share?
Shareholders usually think in terms of the number of shares they own-or plan to buy or sell- so reducing profit to a per-share amount gives a useful number for determining the investment return.
In fact, earnings per share is such an important measure that it must be presented in the financial statements for publicly traded companies. It is the only ratio with this requirement. Private corporations reporting under Accounting Standards for Private Enterprises are not required to report earnings per share.
Profitability: Are comparisons of earnings per share meaningful to companies?
Comparisons of earnings per share are not very meaningful among companies, because of the wide variation in the number of shares and in the financing structures. This is why there is no industry average for earnings per share [for comparison].
Profitability: What is Price-Earnings Ratio, what does it measure and how is it calculated?
Is Price-Earnings Ratio a measure of corporate profitability?
Amounts from earnings per share can be used to calculate the price-earnings (P-E) ratio, which can be compared across companies. The price-earnings ratio is a frequently quoted statistic that measures the ratio of the stock market price of each common share to its earnings per share. It is calculated by dividing the market price per share by earnings per share. The P-E ratio shows what investors expect of a company’s future profitability. The ratio of the share price to profit will be higher if investors think that current profit levels will continue or increase; it will be lower if investors think that profits will decline. A high ratio suggests the market expects good performance, although it may also suggest that shares are overvalued.
Example:
90,000/90,000= $1.00 earnings per share, $12/$1 = 12 times price-earnings ratio
40,000/50,000 = $0.80 earnings per share , $8/$0.80 = 10 times price-earning ratio
P-E ratio is not really a measure of “corporate” profitability but rather a profitability ratio used by investors for valuation purposes.
How to determine how a company can meet its short-term obligations?
Info needed for decision: current assets and current liabilities
Tools to use for decision:
working capital = current assets - current liabilities
Current ratio = current assets\current liabilities
How to evaluate results:
A higher amount indicates liquidity.
A higher ratio suggest favourable liquidity
What is favourable in each ratios?
Liquidity:
Working capital- positive is favourable, higher amount indicates liquidity
Current ratio- higher ratio suggests favourable liquidity
Solvency:
Debt to total assets- lower percentage suggests favourable solvency
Profitability:
