Week 23 - Measures of Solvency and Liquidity

Question 1

What is solvency in finance?

Answer 1

The ability of a business or individual to meet long-term liabilities when they come due.

Question 2

What happens if a business becomes completely insolvent?

Answer 2

It may have to declare bankruptcy.

Question 3

What is liquidity?

Answer 3

A business’s ability to pay off current liabilities using current assets; focuses on short-term financial health.

Question 4

What is the most liquid asset?

Answer 4

Cash—either on hand or in the bank.

Question 5

What is a key difference between solvency and liquidity?

Answer 5

Solvency is about long-term financial health, while liquidity is about short-term cash availability.

Question 6

What does liquidity measure?

Answer 6

The ease of converting assets into cash without significant loss

Question 7

What does solvency assess?

Answer 7

How well a business can sustain itself in the long run and remain financially viable.

Question 8

What are common liquidity ratios?

Answer 8

Current ratio and quick ratio.

Question 9

What are common solvency ratios?

Answer 9

Debt-to-equity ratio and interest coverage ratio.

Question 10

In what order do current assets appear on the balance sheet?

Answer 10

In order of liquidity, from most to least liquid.

Question 11

What does the current ratio measure?

Answer 11

A firm’s ability to pay current liabilities using current assets.

Question 12

What is the formula for the current ratio?

Answer 12

Current ratio = Current Assets ÷ Current Liabilities

Question 13

What time frame is considered “current” in financial statements?

Answer 13

Generally, amounts to be received or paid within one year.

Question 14

What is a generally acceptable current ratio?

Answer 14

Between 1.5 and 2, but it depends on the industry.

Question 15

What does a low current ratio indicate?

Answer 15

Possible liquidity problems—difficulty meeting short-term obligations.

Question 16

What does a high current ratio suggest?

Answer 16

Possible underutilisation of assets—too much in liquid assets, potentially missing growth opportunities.

Question 17

Current Ratio
12
Example: J Sainsbury plc 2020
* Current Assets: £7,586m
* Current Liabilities: £12,047m

Answer 17

Current ratio = 7,586/ 12,047 = 0.63

• Interpretation:
• Sainsbury has £0.63 of current assets for every £1 of current liabilities.

Question 18

What does the quick ratio (acid test) measure?

Answer 18

A more stringent test of liquidity, excluding inventory due to its lower liquidity (i.e., it’s harder to turn into cash quickly).

Question 19

What is the formula for the quick ratio?

Answer 19

Quick ratio = (Current Assets - Inventories)/ Current liabilities

Question 20

What is considered a good quick ratio?

Answer 20

A ratio of at least 1, although this can vary depending on the industry and business size.

Question 21

Why is the quick ratio more stringent than the current ratio?

Answer 21

Because it excludes inventory, which is harder to turn into cash in a hurry compared to other current assets like receivables or cash.

Question 22

Who is doing better in terms of current ratio: Morrison 0.73 or Tesco 0.39?

Answer 22

Tesco is doing better, as it has a higher current ratio (0.73 vs. 0.39), meaning it is more likely to have sufficient assets to cover its liabilities.

Question 23

What does a current ratio below 1 suggest for a company?

Answer 23

It suggests that the company may have insufficient current assets to cover its current liabilities, potentially indicating liquidity issues.

Question 24

Why might Tesco have a higher current ratio than Morrison?

Answer 24

It could be because Tesco has more current assets, or it might have excess inventory that it cannot easily sell. In this case, it may not be paying off liabilities quickly, or it might be holding too much stock.

Question 25

Why is a current ratio below 1 not uncommon in the supermarket industry?

Answer 25

Supermarkets often have high inventory turnover and work with suppliers on short-term credit, allowing them to operate with lower current ratios without facing significant liquidity problems.

Question 26

Quick Ratio or Acid Test Example: J Sainsbury plc 2020 * Current Assets: £7,586m * Inventory: £1,732m * Current Liabilities: £12,047m

Answer 26

(7,586 - 1,732)/ 12,047 = 0.49 * Interpretation * Sainsbury has £0.49 of liquid assets for every £1 of current liabilities.

Question 27

What does the quick ratio measure?

Answer 27

The quick ratio measures a company's ability to pay its current liabilities using its most liquid assets (excluding inventory, which is harder to convert to cash quickly).

Question 28

What is the desired quick ratio?

Answer 28

Generally, a quick ratio greater than 1 is ideal, though industry variations may apply. A ratio below 1 can be common in industries like supermarkets due to their high inventory turnover.

Question 29

In the case of Tesco and Morrison, which company has the higher quick ratio?

Answer 29

Tesco has a higher quick ratio, meaning it is less likely to have liquidity issues compared to Morrison.

Question 30

What might explain the difference in quick ratios between Tesco and Morrison?

Answer 30

The difference could be due to several factors: Tesco may be better at managing current liabilities (such as paying off short-term debts). Tesco might be more risk-averse, holding onto more cash than necessary, potentially missing opportunities to reinvest in the business.

Question 31

Why might Tesco have a high quick ratio?

Answer 31

It could indicate that Tesco is holding more cash or liquid assets, possibly as a safety buffer to avoid liquidity problems. However, this might also suggest that Tesco is less efficient at using its cash reserves for reinvestment and growth.

Question 32

Is it always better for a company to have a high quick ratio?

Answer 32

Not necessarily. A high quick ratio can indicate that the company is holding too much liquid assets (like cash), which could be used for investment opportunities to grow the business. On the other hand, a very low ratio could signal liquidity problems.

Question 33

What trend is observed in J Sainsbury Plc's liquidity ratios from 2009 to 2020?

Answer 33

Both the current ratio and quick ratio show slight improvement, moving closer to or above 1, suggesting improving liquidity.

Question 34

What does a current ratio or quick ratio greater than 1 imply?

Answer 34

It suggests that the company has enough current assets to cover its current liabilities.

Question 35

What explains the difference between the current ratio and quick ratio?

Answer 35

The difference is largely due to the value of inventory, which is excluded from the quick ratio but included in the current ratio.

Question 36

What does a declining difference between the current and quick ratio suggest?

Answer 36

It implies that inventory has decreased as a proportion of current assets, indicating better inventory management or a lower inventory level.

Question 37

Why might J Sainsbury have reduced inventory relative to current assets?

Answer 37

Possible reasons include: Improved inventory management (e.g., more efficient supply chain) Lower inventory due to high demand or supply constraints

Question 38

What is the main factor explaining the difference between the current ratio and the quick ratio?

Answer 38

Inventory, since it is included in the current ratio but excluded from the quick ratio.

Question 39

In which types of industries is there virtually no difference between the current and quick ratios?

Answer 39

Industries with little or no inventory, such as: Software companies (e.g., Microsoft) Consulting firms (e.g., Accenture) Streaming services (e.g., Netflix)

Question 40

Why are current and quick ratios considered crude measures of liquidity?

Answer 40

Because they offer only a basic snapshot and do not reliably predict whether a company will become insolvent or liquidate.

Question 41

What are users of financial statements primarily interested in when examining liquidity?

Answer 41

Whether the company: Can pay its debts, or Is at risk of going into liquidation in the near future.

Question 42

Has research into bankruptcy prediction produced reliable indicators?

Answer 42

No—there has been much research, but little success in identifying indicators that consistently predict insolvency.

Question 43

What is overtrading?

Answer 43

It occurs when a company expands operations too quickly without sufficient capital or liquidity to support the growth.

Question 44

What are signs that a company is overtrading?

Answer 44

The company takes on more business than it can financially handle or operates beyond its financial capacity.

Question 45

How does overtrading typically affect a company’s finances?

Answer 45

It causes the company to expand sales/operations faster than its working capital can support, leading to cash flow problems.

Question 46

What is an example of overtrading?

Answer 46

A retail firm doubles its store count and sales in a year but doesn't increase working capital, leading to inventory shortages, staffing issues, and payment delays.

Question 47

Why does overtrading matter?

Answer 47

It can lead to serious financial issues such as liquidity crises, supply problems, planning failures, and even business failure.

Question 48

What are the impacts of overtrading on a business?

Answer 48

Liquidity crises (cash shortages, low current ratios) Supply problems (strained supplier relationships, loss of credit terms) Planning issues (poor forecasting, inventory mismatch) Business failure, even if the firm is profitable on paper

Question 49

What are the causes of overtrading?

Answer 49

Rapid expansion, especially in young businesses Managerial miscalculations (underestimating costs or overestimating demand) Lack of access to external financing

Question 50

Why must a business ensure sufficient financing as it grows?

Answer 50

To avoid overtrading, which can lead to liquidity problems and financial instability.

Question 51

What are the classic symptoms of overtrading?

Answer 51

Rapid sales growth without matching cash flow (often due to credit sales) High non-current assets and low liquid assets (especially cash) Persistent use of bank overdraft or excessive borrowing Low current and quick ratios Long inventory holding period Increases in payables and receivables periods

Question 52

Which type of company is most at risk of overtrading?

Answer 52

Companies with low current and quick ratios, such as Morrison, suggesting difficulty meeting short-term obligations.

Question 53

Why does a low current or quick ratio suggest overtrading risk?

Answer 53

It may indicate the company is operating beyond its financial capacity, struggling to fund its day-to-day operations.

Question 54

What additional evidence would you look at to assess overtrading risk?

Answer 54

Levels of cash on hand Use of short-term credit/overdrafts Ability to pay suppliers on time Speed of inventory turnover Efficiency in collecting cash from customers