Question

12.4 Explain how calculating current cash debt coverage for an entity overcomes a disadvantage of the current and quick ratios.

Answer 1

Disadvantages of Current and Quick Ratios:

1.The Liabilities have to be paid in cash. But these ratios consider accounts receivable also for calculating the ratio. Current ratio also considers Inventory for calculation. All of inventory and accounts receivable may not be convertible into cash. Hence these ratios are not accurate representation of liquidity

2.These ratios are calculated based on year end balance. These show liquidity at a point of time , ie end of year

Current cash debt coverage ratio indicates the relationship between net cash provided by operating activities and the average current liabilities of the company. It represents the ability of the business to pay its current liabilities from its operations.

This ratio indicates liquidity more accurately.

Current Debt Coverage Ratio=(Net Cash Provided by Operating Activities)/(Average Current Liabilities)

This ratio is not calculated based on year end balance. Hence, it better indicates liquidity during the whole year.