Short Term Solvency

Ratios of short-term solvency measure the ability of the firm to meet recurring financial obligations (that is, to pay its bills). To the extent a firm has sufficient cash flow, it will be able to avoid defaulting on its financial obligations and, thus, avoid experiencing financial distress. Accounting liquidity measures short-term solvency and is often associated with net working capital, the difference between current assets and current liabilities. Recall that current liabilities are debts that are due within one year from the date of the balance sheet. The basic source from which to pay these debts is current assets.

The most widely used measures of accounting liquidity are the current ratio and the quick ratio.

Current Ratio To find the current ratio, divide current assets by current liabilities. For the U.S. Composite Corporation, the figure for 20X2 is

If a firm is having financial difficulty, it may not be able to pay its bills (accounts payable) on time or it may need to extend its bank credit (notes payable). As a consequence, current liabilities may rise faster than current assets and the current ratio may fall. This may be the first sign of financial trouble. Of course, a firm's current ratio should be calculated over several years for historical perspective, and it should be compared to the current ratios of other firms with similar operating activities.

Quick Ratio The quick ratio is computed by subtracting inventories from current assets and dividing the difference (called quick assets) by current liabilities:

Total current assets 761

Current ratio

1.57

Total current liabilities 486

Quick ratio

Quick assets 492

1.01

Total current liabilities 486

Quick assets are those current assets that are quickly convertible into cash. Inventories are the least liquid current assets. Many financial analysts believe it is important to determine a firm's ability to pay off current liabilities without relying on the sale of inventories.

34 Part I Overview

Borrowing Basics

Borrowing Basics

Some small business persons cannot understand why a lending institution refused to lend them money. Others have no trouble getting funds, but they are surprised to find strings attached to their loans.

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