In: Finance
2. Liquidity ratios
Most firms borrow money to finance some of their assets, and most will choose to borrow some long-term funds and some short-term funds. Which group of lenders would put greater emphasis on a firm’s liquidity ratio when evaluating a potential borrower?
Short-term lenders
Long-term lenders
The most recent data from the annual balance sheets of Free Spirit Industries Inc. and LeBron Sports Equipment Inc. are as follows:
Balance Sheet December 31stst(Millions of dollars)
LeBron Sports Equipment Inc. |
Free Spirit Industries Inc. |
LeBron Sports Equipment Inc. |
Free Spirit Industries Inc. |
||
---|---|---|---|---|---|
Assets | Liabilities | ||||
Current assets | Current liabilities | ||||
Cash | $861 | $553 | Accounts payable | $0 | $0 |
Accounts receivable | 315 | 203 | Accruals | 190 | 0 |
Inventories | 924 | 594 | Notes payable | 1,075 | 1,012 |
Total current assets | 2,100 | 1,350 | Total current liabilities | 1,265 | 1,012 |
Net fixed assets | Long-term bonds | 1,547 | 1,238 | ||
Net plant and equipment | 1,650 | 1,650 | Total debt | 2,812 | 2,250 |
Common equity | |||||
Common stock | 610 | 488 | |||
Retained earnings | 328 | 262 | |||
Total common equity | 938 | 750 | |||
Total assets | 3,750 | 3,000 | Total liabilities and equity | 3,750 | 3,000 |
Free Spirit Industries Inc.’s quick ratio is , and its current ratio is ; LeBron Sports Equipment Inc.’s quick ratio is , and its current ratio is .
Which of the following statements are true? Check all that apply.
Free Spirit Industries Inc. has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than LeBron Sports Equipment Inc..
A current ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities.
If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.
Free Spirit Industries Inc. has a better ability to meet its short-term liabilities than LeBron Sports Equipment Inc.
An increase in the current ratio over time always means that the company’s liquidity position is improving.
Solution :
Question 2 )
Part A )
Short term lenders looks for liquidity ratio as this ratio shows position of the company to pay short term obligations.
Hence correct answer will be short term lenders
Part B )
Current ratio of Free Spirit Industries Inc.’s = Current asset / Current liability = 1350/1012 = 1.33
Quick ratio of Free Spirit Industries Inc.’s = (Current asset - Inventory)/ Current liability = (1350 - 594)/1012 = 0.75
Current ratio of LeBron Sports Equipment Inc.’s = Current asset / Current liability = 2100/1265 = 1.66
Quick ratio of LeBron Sports Equipment Inc.’s = (Current asset - Inventory)/ Current liability = (2100 - 924)/1265= 0.93
Part C )
Statement 1: Free Spirit Industries Inc. has less liquidity but also a greater reliance on outside cash flow to finance its short-term obligations than LeBron Sports Equipment Inc.
Current ratio and quick ratio of Free Spirit is lower than the ratio of LeBron. Hence they rely more on outside finance to meet short term obligation.
This statement is correct
Statement 2: A current ratio of 1 indicates that the book value of the company’s current assets is equal to the book value of its current liabilities.
Current ratio = Current assets / current liability
Ratio of 1 means current asset is equal to current liaility
This statement is correct
Statement 3: If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the difference between the two ratios is large, then the company depends heavily on the sale of its inventory to meet its short-term obligations.
This statement is correct as quick ratio = (Current assets - Inventory )/ Current liability
This statement is correct
Statement : 4 Free Spirit Industries Inc. has a better ability to meet its short-term liabilities than LeBron Sports Equipment Inc.
Free spirit has less liquidity ratio than LeBron. Hence they have lower ability to meet short term obligations
This statement is incorrect
Statement:5
An increase in the current ratio over time always means that the company’s liquidity position is improving.
HIgher current ratio means better liquidity position
This statement is correct