Business Degree Certification Practice Test

Which financial ratio category is best for assessing a firm's cash availability for bills?

1. Liquidity

2. Leverage

3. Efficiency

4. Profitability

The correct answer is: Liquidity

The liquidity ratio category is specifically designed to assess a firm's ability to meet its short-term obligations, such as paying bills. This category primarily includes ratios like the current ratio and quick ratio, which evaluate the availability of liquid assets compared to current liabilities. A higher liquidity ratio indicates that the firm has ample cash or easily convertible assets to comfortably cover its immediate financial commitments. For example, the current ratio measures current assets, such as cash, accounts receivable, and inventory, against current liabilities. A firm with a strong liquidity position demonstrates financial health, as it can readily access funds to address operational costs and unforeseen expenses. This is crucial for maintaining smooth operations and avoiding insolvency. The other categories, such as leverage, efficiency, and profitability, focus on different aspects of a company's financial standing. Leverage ratios assess the extent of a firm's debt relative to its equity, efficiency ratios evaluate how well a company utilizes its assets to generate sales, and profitability ratios measure a firm’s ability to generate earnings relative to its revenue or assets. While these are important for overall financial analysis, they do not specifically evaluate the availability of cash for immediate expenses like liquidity ratios do.