101 Concepts for the Level I Exam

Concept 48: Liquidity and Solvency Ratios

Liquidity ratios measure a company’s ability to meet current liabilities. The higher the liquidity ratio, the more likely the firm will be able to meet its short term obligations.

Current ratio – It is the most widely used measure of liquidity.

Current ratio = current assets / current liabilities

$Current\ ratio=\ {{current\ assets}\over {current\ liabilities}}$

Quick ratio – It is a more conservative measure of liquidity. It excludes inventories and less liquid assets from the numerator

$]$$Quick\ ratio=\ {{cash+marketable\ securities+receivables}\over {current\ liabilities}}$$$

Cash ratio – It is the most conservative measure of liquidity. Even receivables are excluded from the numerator.

$Cash\ ratio=\ {{cash+marketable\ securities}\over {current\ liabilities}}$

Solvency ratios measure a company’s ability to meet long-term obligations. A high ratio indicates high leverage and a high financial risk.

Long term debt to equity ratio — It measures long term financing sources relative to total equity.

$Long\ term\ debt\ to\ equity=\ {{total\ long\ term\ debt}\over {total\ equity}}$

Debt to equity ratio– It measures total debt relative to total equity.

$Debt\ to\ equity=\ {{total\ debt}\over {total\ equity}}$

Total debt to assets ratio – It measures the extent to which assets are financed by liabilities.

$Debt\ to\ assets=\ {{total\ debt}\over {total\ assets}}$

Financial leverage ratio – It measures total assets relative to total equity.

$Financial\ leverage\ ratio=\ {{total\ assets}\over {total\ equity}}$