Question

1- a) What is the importance of liquidity? USE YOUR OWN WORDS

      b) List and briefly describe the five categories of business ratios. USE YOUR OWN WORDS

Answer 1

Solution a.

Liquidity basically tells us how hard or how easy it is to turn the company's assets or the company's security into cash. If the asset/security can be easily converted into cash, we can say it is a more liquid asset.

Importance:

1> Liquidity helps us in the case of any emergency that our company faces. Hence some portion of the company's net worth should always be kept liquid so that it is there whenever we need it.

2> Liquidity helps when company needs to borrow money. Potential investors and creditors see the liquidity ratios of businesses and determine whether this company is stable and strong enough to face difficult times.

3> Liquidity crisis may bring insolvency or bankruptcy. The only option company will have at that time is to sell its fixed assets or any other investment to get cash.

4> Liquidity helps in a case when a supplier is offering a favorable discount or any new immediate profitable opportunity arises for the company.

Solution b.

Business ratios are the ratios to determine the efficiency of the business.

a. Leverage Ratios: They give us an idea upto what extent company is using long term debt to support the business or in other words company's long-term solvency.

For e.g. Debt-to-asset ratio, Debt-to-equity ratio

b. Liquidity Ratios: They measure the amount of cash/easily converted assets that a comapany have to cover its debt.

For e.g. Quick ratio, Current ratio

c. Profitability ratios: They are used to compare the business to others in the industry, and not only to evaluate the financial viability of the business.

For e.g. Net Profit Margin, Return on Investment (ROI)

d. Turnover Ratios: They are also known as asset efficiency ratios. They measure how efficient a business is in using its assets.

For e.g. Inventory turnover, Receivables turnover

e. Market Value Ratios: These ratios rely on a company's current share price and provide a clear scenario of whether or not the stock makes a satisfying investment at current levels.

For e.g. Price/Earnings (P/E), Price/Cash Flow, Price/Sales (P/S), Price/Earnings/Growth Rate (PEG).

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