CFA Level II ExamFixed IncomeMedium
A credit analyst is evaluating a company's financial health using various ratios. The company has a current ratio of 1.8x, a quick ratio of 0.9x, and a cash ratio of 0.2x. Which of the following statements is the most appropriate conclusion based on these ratios?
- AThe company is highly liquid across all short-term measures, indicating low credit risk.
- BThe company's current assets are insufficient to cover its current liabilities without selling inventory.
- CThe company has strong short-term liquidity, primarily due to its high level of cash.
- DThe company's liquidity is largely dependent on its inventory, which poses a potential risk.
Show answer & explanationAnswer & explanation
Correct answer: D. The company's liquidity is largely dependent on its inventory, which poses a potential risk.
The significant drop from the current ratio (1.8x) to the quick ratio (0.9x) indicates that a large portion of the company's current assets is tied up in inventory. If the company struggles to sell its inventory, its ability to meet short-term obligations could be compromised, posing a liquidity risk.
Why the other options are wrong
- A. The quick and cash ratios are below 1, indicating that liquidity is not strong across all measures.
- B. The current ratio of 1.8x indicates current assets are sufficient to cover current liabilities, but the composition is a concern.
- C. The cash ratio of 0.2x indicates a low level of cash, not a high one.
Liquidity Ratios Interpretation
Financial ratios used to assess a company's ability to meet its short-term obligations.
- Current Ratio: Current Assets / Current Liabilities.
- Quick Ratio: (Current Assets - Inventory) / Current Liabilities.
- Cash Ratio: Cash / Current Liabilities.
- A large gap between current and quick ratios implies reliance on inventory.
Memory trick: CRitical Quick Cash Checks Company's Capability.