Chapter 17, Problem 1DQ

To determine

Determine the differences between liquidity, solvency, and profitability ratios.

Explanation of Solution

Financial Ratios: Financial ratios are the metrics used to evaluate the liquidity, profitability, solvency and overall performance of a company.

In general, as said above, financial ratios are mainly used for evaluation of the liquidity, solvency, profitability, and overall performance of a company.

 Thus, following are the financial ratios and their differences:

• Liquidity ratio: Liquidity ratios are used to measure the ability of the company towards fulfilling the obligations and requirements of the cash at the short-term.  The better the ratio the healthier is the company in meeting its short term obligations. Some of the ratios are Current ratio, Acid-test ratio, Inventory turnover ratio.
• Solvency ratio: But the solvency ratios are those ratios used to measure the ability of the company towards survival for a longer period. This ratio indicates the capital structure of the business and shows its leverage position to sustain and run for a long period. Examples are Debt to Equity ratio, Equity to Assets ratio.
• Profitability ratio: On the other hand, profitability ratios are those ratios used to measure the extent of profit earned by the business for a particular time period. Examples are Gross profit margin ratio, Return on equity and Return on assets.