Liquidity And Solvency Analysis Discussion

Liquidity Ratio
Liquidity means that the assets can be easily converted into cash. The ratio helps to study and assess the ability of a business to pay its short-term financial bonds, and it measures the firm’s ability to pay its current dues (i.e., repayable within a year).

The important liquidity ratios are as follows:

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Current ratio

Quick ratio

The current ratio determines the proportion of the current property and the current liabilities of a business. It indicates the ability of an entity to encounter the current liabilities as and when they are due for payment.

{\rm{Current\ ratio}} = \frac{{{\rm{Current\ assets}}}}{{{\rm{Current\ liabilities}}}}Current ratio=
Current liabilities
Current assets

The quick ratio is used for assessing the firm’s short-term liquidity. It can be calculated by the proportion of liquid assets to current liabilities, and it indicates whether the business is in a place to pay its current dues out of its quick property. It is also known as the acid test ratio or liquid ratio.

The higher the increase in the ratio, the better the position of the firm in financial statements.

{\rm{Quick\ ratio}} = \frac{{{\rm{Liquid\ assets}}}}{{{\rm{Current\ liabilities}}}}Quick ratio=
Current liabilities
Liquid assets

Current assets are can be easily converted into cash within a year. This includes cash and cash equivalents (cash in hand and bank), current investments, inventories, trade receivables, stock, and prepaid expenses.

{\rm{Current\ assets}} = \left( \begin{array}{l}{\rm{Cash\ and\ cash\ equivalents}} + {\rm{Current\ investment}} + {\rm{Inventories}} + \\{\rm{Trade \ receivables}} + {\rm{Prepaid \ expenses}}\end{array} \right)Current assets=(
Cash and cash equivalents+Current investment+Inventories+
Trade receivables+Prepaid expenses

Balance sheet
Current Assets Current Liabilities
Cash $7,314 Accounts Payable $6,750
Accounts Receivable $2,000 Short-Term Loans $3,000
Prepaid Expenses $5,260 Income Tax Payable $4,725
Short-term Investment $5,000 Accrued Salaries and wages $1,000
Total Current Assets $19,574 Unearned Revenue $1,200
Fixed (Long Term) Assets Current Portion of Long-Term Debt $1,423
Long Term Investments $5,825 Total Current Liabilities ,098
Property and Plant $16,585 Long-Term Liabilities
Less: Accumulated Depreciation ($2,612) Long-Term Debt $2,670
Intangible Assets $4,500 Long-Term Notes Payable $7,650
Total Fixed Assets $24,298 Total Long-Term Liabilities $10,320
Owner’s Equity
Common Stock $9,200
Retained Earnings $6,254
Total Stockholder’s Equity $15,454
Total Assets $43,872 Total Liabilities and Stockholder’s Equity $43,872
Current liabilities are the financial obligations that are repayable in a short time (i.e., within a year or a period of an operating cycle). This includes trade payable, short term borrowings, expenses payable, etc.

{\rm{Current\ Liabilities}} = {\rm{Trade\ payables}} + {\rm{Short \ term\ borrowing}} + {\rm{Expenses \ payable}}Current Liabilities=Trade payables+Short term borrowing+Expenses payable

Quick assets are current properties once inventories and prepaid expenses have been eliminated.

{\rm{Quick\ assets}} = {\rm{Current\ assets}} – {\rm{Prepaid\ expenses}} – {\rm{Inventories}}Quick assets=Current assets−Prepaid expenses−Inventories

Solvency Ratio
Solvency refers to a firm’s ability to pay its accountability in the long run. The ratio of solvency measures a firm’s cash flow, and whether or not it is sufficient for its long-term obligations. The value of entity properties must be greater than the sum of its debt obligations. When a firm’s solvency ratio decreases, it is more likely to have debt obligations. So, solvency is necessary for a firm to stay in its field. It also determines whether a firm will continue its operations in the upcoming events.

The important solvency ratios are as follows:

Debt-to-equity ratio

Proprietary ratio

The debt-to-equity ratio is calculated to evaluate the ability of a firm to encounter the long-term run. The debt-to-equity ratio divides the firm’s debt to the value of its property of shareholders fund. It indicates whether or not the firm is in too much debt. The lower the debt-to-equity ratio, the lower the risk for the long-term lender. The higher the ratio, the more likely it is that the firm will shut down.

{\rm{Debt\ equity\ ratio }} = \frac{{{\rm{Long\ term\ debt}}}}{{{\rm{Shareholders’\ fund}}}}Debt equity ratio=
Long term debt

The proprietary ratio is an entrepreneurial business run by a single person with a certain number of shareholders. This is calculated by the proportion of a shareholder’s fund to the total property. An increase in ratio indicates greater satisfaction for the lenders. It also ensures a shareholder that the firm is less dependent on the external sources of finance.

{\rm{Proprietary \ ratio}} = \frac{{{\rm{Shareholders’ \ fund}}}}{{{\rm{Total \ assets}}}}Proprietary ratio=
Total assets

Long-term debt is equal to the debentures of the firms, and it has a fixed rate of interest for a long-term yield.

A shareholders’ fund is the amount for capital investment of the shareholders in a firm’s investment. This includes a sum of the equity share capital, reserve and surplus, and the preference share capital of the firm.

{\rm{Shareholders’ \ fund}}\; = {\rm{Equity\ share\ capital}} + {\rm{Reserve\ and \ surplus}} + {\rm{Preference\ share\ capital}}Shareholders
fund=Equity share capital+Reserve and surplus+Preference share capital

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