Assess the solvency of a business, Accounting Basics

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Identify and explain the two ratios that are used to assess the solvency of a business.


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2/12/2013 8:07:12 AM

Aswer:

The solvency ratios are the current ratio (working capital ratio) and the acid test (quick ratio). They measure the ability of a business to meet its short term debts. Current ratio is defined as the excess of current assets over current liabilities, and a surplus is normally interpreted as a reliable indication of the fact that a company is solvent. The current ratio is calculated as follows:

Current ratio = Working capital ratio = Current assets / Current liabilities: 1

A general benchmark for the current ratio is 2:1.

The current ratio as a measure of solvency suffers from one limitation, its inclusion of stock. The acid test or quick ratio is used to examine solvency to overcome the limitation of the current ratio. It is calculated as follows:

Acid Test = Current assets - stock/ Current liabilities: 1

A liquidity ratio of 1:1 is desirable in that it affords a company the comfort of knowing it can meet its short term debts. This does not mean that it is a good ratio because what is a good ratio will depend upon a range of other factors, such as; the sector, the company, its reputation, the economy etc.

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