Which of the following indicates an organizations ability to meet its current debt obligations?

Financial ratios are measurements of a business' financial performance. Ratios help an owner or other interested parties develop an understand the overall financial health of the company.

Financial ratios are used by businesses and analysts to determine how a company is financed. Ratios are also used to determine profitability, liquidity, and solvency. Liquidity is the firm's ability to pay off short term debts, and solvency is the ability to pay off long term debts.

Commonly used financial ratios can be divided into the following five categories.

Liquidity and Solvency Ratios

Liquidity ratios focus on a firm's ability to pay its short-term debt obligations. The information you need to calculate these ratios can be found on your balance sheet, which shows your assets, liabilities, and shareholder's equity.

Common liquidity ratios are the current ratio, the quick ratio, and the cash ratio. The current ratio is an indicator of your company's ability to pay its short term liabilities (debts).

The quick ratio (sometimes called the acid-test) is similar to the current ratio. The difference between the two is that in the quick ratio, inventory is subtracted from current assets. Since inventory is sold and restocked continuously, subtracting it from your assets results in a more precise visual than the current ratio.

The cash ratio is different from both the quick and current ratios in that it only takes into account assets that are the easiest to convert into cash. These assets are cash and cash equivalents, such as marketable securities, money orders, or money in a checking account.

The solvency ratio represents the ability of a company to pay it's long term obligations. This ratio compares your company's non-cash expenses and net income after taxes to your total liabilities (short term and long term).

Financial Leverage Ratios

The financial leverage or debt ratios focus on a firm's ability to meet its long-term debt obligations. They use the firm's long-term liabilities on the balance sheet such as payable bonds, long-term loans, or pension funds.

Common financial leverage ratios are the debt to equity ratio and the debt ratio. Debt to equity refers to the amount of money and retained earnings invested in the company.

The debt ratio indicates how much debt the firm is using to purchase assets. In other words, it shows if the company uses debt or equity financing.

Turnover Ratios

Sometimes called asset efficiency ratios, turnover ratios measure how efficiently a business is using its assets. This ratio uses the information found on both the income statement and the balance sheet.

The turnover ratios used most commonly are accounts receivable turnover, accounts payable turnover, and inventory turnover. Accounts receivable turnover indicate how effective your company is at collecting credit debt.

Accounts payable turnover expresses your efficiency at paying your accounts, and inventory turnover is a measurement of the amount of time it takes to consume and restock your inventory.

When used together, turnover ratios describe how well the business is being managed. They can indicate how fast the company's products are selling, how long customers take to pay, or how long capital is tied up in inventory.

Profitability Ratios

These are ratios that measure if a business' activities are profitable. Frequently used ratios are the net profit ratio and the contribution margin ratio. The contribution margin ratio indicates if your products or services are generating a profit after variable expenses.

The net profit ratio expresses profits after taxes to net sales. This ratio illustrates the percentage of profits remaining after taxes and all costs have been accounted for.

Market Value Ratios

There are many market value ratios, but the most commonly used are price per earnings (P/E) and dividend yield.

The P/E ratio is used by investors to determine if a share of a company's stock is over or underpriced. The dividend yield is an important ratio for investors as it illustrates the return on their investment.

The ability of a company to meet its long-term financial obligations

What is Solvency?

Solvency is the ability of a company to meet its long-term financial obligations. When analysts wish to know more about the solvency of a company, they look at the total value of its assets compared to the total liabilities held.

An organization is considered solvent when its current assets exceed current liabilities. This is typically measured using the current ratio. A company is considered solvent if its current ratio is greater than 1:1.

A solvent company is able to achieve its goals of long-term growth and expansion while meeting its financial obligations. In its simplest form, solvency measures if a company is able to pay off its debts over the long term.

Liquidity vs. Solvency

Solvency and liquidity are two ways to measure the financial health of a company, but the two concepts are distinct from each other.

Liquidity refers to the ability of a company to pay off its short-term debts; that is, whether the current liabilities can be paid with the current assets on hand. Liquidity also measures how fast a company is able to covert its current assets into cash.

Solvency, on the other hand, is the ability of the firm to meet long-term obligations and continue to run its current operations long into the future. A company can be highly solvent but have low liquidity, or vice versa. However, in order to stay competitive in the business environment, it is important for a company to be both adequately liquid and solvent.

Assessing the Solvency of a Business

The solvency of a business is assessed by looking at its balance sheet and cash flow statement.

The balance sheet of the company provides a summary of all the assets and liabilities held. A company is considered solvent if the realizable value of its assets is greater than its liabilities. It is insolvent if the realizable value is lower than the total amount of liabilities.

The cash flow statement also provides a good indication of solvency, as it focuses on the business’ ability to meet its short-term obligations and demands. It analyzes the company’s ability to pay its debts when they fall due, having cash readily available to cover the obligations.

The cash flow also offers insight into the company’s history of paying debt. It shows if there is a lot of debt outstanding or if payments are made regularly to reduce debt liability. The cash flow statement measures not only the ability of a company to pay its debt payable on the relevant date but also its ability to meet debts that fall in the near future.

A solvency analysis can help raise any red flags that indicate insolvency. It can uncover a history of financial losses, the inability to raise proper funding, bad company management, or non-payment of fees and taxes.

Other Ratios

Several different ratios can help assess the solvency of a business, including the following:

1. Current debts to inventory ratio

The ability of a company to rely on current inventory to meet debt obligations.

2. Current debt to net worth ratio

The total amount of money owed to shareholders in a year’s time, expressed as a percentage of the shareholder’s investment.

3. Total liabilities to net worth ratio

The relationship between the total debts and the owner’s equity in a company. The higher the ratio, the lower the protection for the business’ creditors.

Conclusion

When assessing the financial health of a company, one of the key considerations is the risk of insolvency, as it measures the ability of a business to sustain itself over the long term. The solvency of a company can help determine if it is capable of growth.

Also, solvency can help the company’s management meet their obligations and can demonstrate its financial health when raising additional equity. Any business looking to expand in the long term should aim to remain solvent.

Additional Resources

CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful:

• Analysis of Financial Statements
• Debt to Assets Ratio
• Liquidity Event
• Net Tangible Assets

Which of the following indicates an organization's ability to meet its current debt obligations?

Which of the following should be used to evaluate a firm's ability to pay its current liabilities?

Which ratio would be used to examine an establishment's ability to meet its long term financial obligations and its financial leverage?

Which of the following focuses on whether performance meets established standards?