Question

You are auditing Southern Farming Association in Goldsboro and would like to use financial ratios to test the ability of the company to meet its current obligations. Identify three ratios that would help in this task. Identify how each ratio is calculated and what a high ratio would signify to you.

Answer 1

Answer:

Liquidity ratios:

To meet the short-term debt requirements, the company’s potential can be measured by liquidity ratios. These ratios measure the company’s potential to pay off when the short-term debt obligations are due. The company is said to be in good financial position when liquidity ratios that are greater than 1. If the liquidity ratios are higher, then we can say that the company has a high margin of safety to meet the short-term debt requirements. Some of the liquidity ratios are as follows:

• Acid-Test Ratio
• Cash Ratio
• Current Ratio
• Working Capital

Acid-Test Ratio:

Also known as the quick ratio, this ratio measures the short-term potential to pay the current liabilities of the company. This ratio is an extension of the current ratio. Quick Ratio can be calculated as follows:

Quick Ratio = Current Assets – Inventory – Prepaid Expenses (If Any)/Current Liabilities

Cash Ratio:

Also known as a cash asset ratio, this is the measure of a company’s potential to pay off the short-term liabilities with funds that are available readily. Cash ratio can be calculated as follows:

Cash Ratio = Cash and Cash Equivalents/Current Liabilities

Current Ratio:

The company’s potential to pay off the short-term obligation with the current assets the company have is measured by the current ratio. Current Ratio is calculated as follows:

Current Ratio = Current Assets/Current Liabilities

Working Capital:

This ratio determines the excess of Current Assets over the current liabilities in a company. This ratio determines how many liquid assets are available in the business. The calculation of working capital is as under:

Working Capital = Current Assets – Current Liabilities