Question

1. Liquidity ratios

A liquid asset can be converted quickly to cash with little sacrifice in its value.

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

Accounts receivable

Inventories

Cash

Points:

1 / 1

Close Explanation

Explanation:

In the event of a liquidation, inventories tend to recover the least amount of their stated value. Cash will not lose value, and accounts receivable are likely to retain their value if there are no bad debts. 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 Corporation and Zebra Paper Corporation are as follows:

Balance Sheet December 31st" role="presentation" style="display: inline; font-weight: normal; line-height: normal; text-align: left; word-spacing: normal; overflow-wrap: normal; float: none; direction: ltr; max-width: none; max-height: none; min-width: 0px; min-height: 0px; border: 0px; padding: 0px; margin: 0px; position: relative;">31st${31}^{\mathrm{st}}$ (Millions of dollars)

	Zebra Paper Corporation	Pellegrini Southern Corporation		Zebra Paper Corporation	Pellegrini Southern Corporation
Assets			Liabilities
Current assets			Current liabilities
Cash	$5,166	$3,321	Accounts payable	$0	$0
Accounts receivable	1,890	1,215	Accruals	1,139	0
Inventories	5,544	3,564	Notes payable	6,455	6,075
Total current assets	$12,600	$8,100	Total current liabilities	$7,594	$6,075
Net fixed assets			Long-term bonds	9,281	7,425
Net plant and equipment	9,900	9,900	Total debt	$16,875	$13,500
			Common equity
			Common stock	$3,656	$2,925
			Retained earnings	1,969	1,575
			Total common equity	$5,625	$4,500
Total assets	$22,500	$18,000	Total liabilities and equity	$22,500	$18,000

Pellegrini Southern Corporation’s current ratio is1.3333   , and its quick ratio is0.7467   ; Zebra Paper Corporation’s current ratio is1.6592   , and its quick ratio is0.9292   . 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 Ratio = Current Assets / Current Liabilities

Pellegrini Southern Corporation				Zebra Paper Corporation
Current Ratio	=	$8,100 / $6,075		Current Ratio	=	$12,600 / $7,594
	=	1.3333			=	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 Ratio = (Current Assets – Inventories) / Current Liabilities

Pellegrini Southern Corporation				Zebra Paper Corporation
Quick Ratio	=	($8,100 – $3,564) / $6,075		Quick Ratio	=	($12,600 – $5,544) / $7,594
	=	0.7467			=	0.9292

Which of the following statements are true? Check all that apply.

Zebra Paper Corporation has a better ability to meet its short-term liabilities than Pellegrini Southern Corporation.

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.

Compared to Pellegrini Southern Corporation, Zebra Paper Corporation has less liquidity and a lower reliance on outside cash flow to finance its short-term obligations.

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