Measures of Solvency and Liquidity

Question 1

What is solvency?

Answer 1

• The ability to cover liabilities when they fall due
• Potential problem if current assets < current liabilities

Question 2

What is liquidity?

Answer 2

• Refers to the ease of turning an asset into cash
  (without loss)
• Cash (at hand and in bank) is most liquid

Question 3

What does the current ratio (current assets/ current liabilities) indicate?

Answer 3

ability to pay current liabilities from current assets

Question 4

What is generally a good ratio?

Answer 4

Between 1.5 and 2 but heavily industry dependent

Question 5

If Sainsburys has a current ratio of 0.63, what does that mean?

Answer 5

Sainsbury has £0.63 of current assets for every £1 of current liabilities.

Question 6

Quick ratio or acid test formula

Answer 6

(current assets- inventories)/ current liabilities

Question 7

What does the quick ratio tell us?

Answer 7

Quick ratio tells us whether the company has sufficient assets to cover its current liabilities, after excluding inventories because they are the least liquid asset.

Question 8

What is over-trading?

Answer 8

Too many non-current assets and too few liquid assets (especially cash)

Question 8

If Sainsburys has a quick ratio of 0.49, what does that mean?

Answer 8

Sainsbury has £0.49 of liquid assets for every £1 of current liabilities.

Question 9

What are four impacts of overtrading

Answer 9

• Liquidity problems
• Supply problems
• Planning problems
• Business failure

Question 10

When might overtrading occur?

Answer 10

• Young, expanding business
• Manager mis-calculation (sales demand and/or costs)
• Unavailability of financing

Question 11

Symptoms of overtrading

Answer 11

• Persistent use of bank overdraft facility
• Working capital ratios and liquidity ratios are likely to be affected:
• Significant increases in payment payables periods and settlement
  periods for receivables
• Long inventory holding period
• Low current and quick ratios