2.

Liquidity ratios

A liquid asset can be converted to cash quickly without significantly impacting the asset’s value.

Which of the following asset classes is generally considered to be the most liquid?

Cash

Accounts receivable

Inventories
Points:
1/1

Close Explanation

Explanation:

In the event of a liquidation, inventories tend to recover the least amount of their stated value.

Accounts receivable are likely to retain their value if there are no bad debts. But cash is already liquid,

so it will not lose value.

That is why the quick ratio adjusts current assets by subtracting inventories. Whereas the current

ratio compares current assets expected to be converted to cash in the next year to current liabilities

expected to be due in the next year, the quick ratio asks what would happen if the firm were

liquidated today and whether it would have enough liquid assets to meet short-term creditors.

The most recent data from the annual balance sheets of Pellegrini Southern Inc. and Jing Foodstuffs

Inc. are as follows:

Balance Sheet December 31stst(Millions of dollars)

Jing Pellegrini Jing Pellegrini

Foodstuffs Southern Foodstuffs Southern
Inc. Inc. Inc. Inc.
Assets Liabilities
Current Current
assets liabilities
Cash $4,879 $3,136 Accounts $0 $0
payable
Accounts 1,785 1,148 Accruals 1,076 0
receivable
Inventories 5,236 3,366 Notes 6,096 5,737
payable
 Jing Pellegrini Jing Pellegrini
Foodstuffs Southern Foodstuffs Southern
Inc. Inc. Inc. Inc.
Total current 11,900 7,650 Total current 7,172 5,737
assets liabilities
Net fixed Long-term 8,765 7,013
assets bonds
Net plant and 9,350 9,350 Total debt 15,937 12,750
equipment
Common
equity
Common 3,453 2,763
stock
Retained 1,860 1,487
earnings
Total 5,313 4,250
common
equity
Total assets 21,250 17,000 Total 21,250 17,000
liabilities
and equity

Pellegrini Southern Inc.’s current ratio is 1.3334    , and its quick ratio is 0.7467    ; Jing

Foodstuffs Inc.’s current ratio is 1.6592    , and its quick ratio is 0.9292    . Note: Round

your values to four decimal places.

Points:
1/1

Close Explanation

Explanation:

The current ratio measures the extent to which a firm’s current liabilities are covered by the assets

that the firm expects to be converted into cash in the next fiscal year, or its current assets. The

current ratio is calculated as follows:

Current = Current Assets / Current Liabilities

Ratio
Pellegrini Southern Inc. Jing Foodstuffs Inc.
 Current Ratio = $7,650 / Current Ratio = $11,900 /
$5,737 $7,172
= 1.3334 = 1.6592
The quick ratio, also called the acid test ratio, measures a company’s ability to meet its short-term

obligations using its most liquid assets. Because inventories are considered to be the least liquid of a

firm’s current assets, the quick ratio excludes inventories from current assets and is calculated as

follows:

Quick = (Current Assets – Inventories) / Current

Ratio Liabilities
Pellegrini Southern Inc. Jing Foodstuffs Inc.
Quick = ($7,650 – Quick Ratio = ($11,900 –
Ratio $3,366) / $5,737 $5,236) / $7,172
= 0.7467 = 0.9292
Which of the following statements are true? Check all that apply.

Pellegrini Southern Inc. has less liquidity but also a greater reliance on outside cash flow to

finance its short-term obligations than Jing Foodstuffs Inc..

If a company’s current liabilities are increasing faster than its current assets, the company’s

liquidity position is weakening.

If a company has a quick ratio of less than 1 but a current ratio of more than 1 and if the

difference between the two ratios is large, then the company depends heavily on the sale of its

inventory to meet its short-term obligations.

Pellegrini Southern Inc. has a better ability to meet its short-term liabilities than Jing Foodstuffs

Inc.

An increase in the current ratio over time always means that the company’s liquidity position is

improving.
Points:
1/1

Close Explanation

Explanation:

Pellegrini Southern Inc.’s current ratio (1.3334) is lower than Jing Foodstuffs Inc.’s current ratio

(1.6592), which means that Pellegrini Southern Inc.’s ability to finance its short-term liabilities is less

than Jing Foodstuffs Inc.’s ability to finance its short-term liabilities. Pellegrini Southern Inc. has a

greater reliance on outside funds to finance its short-term obligations than Jing Foodstuffs Inc.
The current ratio illustrates a company’s liquidity by evaluating its ability to cover short-term current

liabilities with short-term current assets. If current liabilities are increasing faster than current assets,

the company will have fewer current assets to liquidate to meet its short-term obligations, if needed.

If this trend persists for too long, the company may have to borrow long-term debt to meet its short-

term liabilities.

A quick ratio of less than 1 means that the company does not have enough assets, excluding its

inventory, to meet its short-term obligations. The quick ratio does not take into account the value of

the company’s inventory. The quick ratio is calculated by subtracting inventory from current assets

and then dividing that value by current liabilities. If this ratio is less than 1 and the current ratio is

more than 1, then the inventory constitutes a major part of the company’s current assets. The

company would have to depend on liquidating its inventory to meet its short-term obligations.

An increase in the current ratio does not always mean an improvement in the company’s liquidity

position. If a company’s current assets are increasing, it could indicate that the firm has too much old

inventory that will have to be written off or too many old accounts receivable that may turn into bad

debts. A very high current ratio could also signal that the firm is not managing its assets efficiently.