Question

ASSIGNMENT 7.1. USING RATIOS TO ASSESS CURRENT AND LONG-TERM LIABILITIES In FY 2010, the MLK Settlement House has total assets of $1.2 million and current assets of $300,000. Its current liabilities are $200,000, and its long-term liabilities are $800,000. What ratios can be used with these data? What would the answers be? Given the fact that there is only one year's worth of data, what conclusions can you draw?

Answer 1

Two types of ratios can be used there; these are “liquidity ratio” and “solvency ratio”.

Liquidity ratio:

This type of ratio indicates firm’s financial capacity to meet short-term obligations. It includes current ratio.

Current ratio = TotalCurrent Assets / TotalCurrent liabilities

                        = 300,000 / 200,000

                        = 1.5

Solvency ratio:

This type of ratio indicates both short-term and long-term financial strength of a firm. It includes debt ratio.

Debt ratio = TotalDebt / TotalAssets

                  = (200,000 + 800,000) / 1,200,000

                  = 1,000,000 / 1,200,000

                  = 0.83

Conclusions:

No.1) the firm has sound ability in liquidity, since its current ratio is 1.5; it means each short-term liability is backed by 1.5 current assets (like cash, accounts receivable, etc.).

No.2) solvency is at risk, since its debt ratio (0.83) is above the industry average (0.40). This means 83% value of assets are financed through debt, which should not be more than 40%.

No.3) there is an alert for investors not to invest in the firm for long-term purpose. It is better to have short-term investment.