Financial Ratios and Interpretations

In: Business and Management

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LIQUIDITY RATIOS
Interpretation of liquidity Ratios
In order to survive, firms must be able to meet their short-term obligations—pay their creditors and repay their short-term debts. Thus, the liquidity of the firm is one measure of a firm's financial health. Two measures of liquidity are in common:
Current ratio = current assets / current liabilities The main difference between the current ratio and the quick ratio is that the latter does not include inventories, while the former does. Which ratio is a better measure of a firm's short-term position? In some ways, the quick ratio is a more conservative standard. Quick ratio = (cash + marketable securities + net receivables) / current liabilities
If the quick ratio is greater than one, there would seem to be no danger that the firm would not be able to meet its current obligations. If the quick ratio is less than one, but the current ratio is considerably above one, the status of the firm is more complex. In this case, the valuation of inventories and the inventory turnover are obviously critical. A number of problems with inventory valuation can contaminate the current ratio. An obvious accounting problem occurs because organizations value inventories using either of two methods, last in, first out (LIFO) or first in, first out (FIFO). Under the LIFO method, inventories are valued at their old costs. If the organization has a substantial quantity of inventory, some of it may be carried at relatively low cost, assuming some inflation in overall prices. On the other hand, if there has been technical progress in a market and prices have been falling, the LIFO method will lead to an overvalued inventory.

Under the FIFO method of inventory valuation, inventories are valued at close to their current replacement cost. Clearly, if we have firms that differ in their…...

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