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What ratios measure a corporation's liquidity? What are some problems associated with using such ratios? How would the DuPont analysis overcome these problems?
We know that a corporation's liquidity is it's ability to pay off short-term debt. It's liquidity depends on the amount of liquid assets the corporation can convert to cash.
A few ratios that can measure a corporation's liquidity are:
(1.) ratio of liquid assets divided by company's short-term liabilities. This is called the CURRENT RATIO.
But there are problems associated with this because not all the liquid assets can be sold at FULL VALUE, hence we could over-estimate the current ratio if some of the assets are sold at a lower value.
(2.) Operating Cash Flow Ratio is equal to Operating cash flow value divided by Current Liabilities. Operating cash flow is the company's income earned by it's business operations. This is another way to measure the ability to pay short-term debt based on the company's income, rather than on convertible assets. There could be a problem here, what if the company lies about where it gets its income. What if the company is taking a loan from a bank and reporting that as its income?
(3.) Another one is the Quick Ratio. The quick ratio is equal to (current assets minus inventories and prepayments) divided by current liabilities. This ratio actually considers the assets that can readily be converted to cash and compare it to the current liabilities. Again this measure has problems in the fact that the assets could be undervalued or overvalued. It does not consider the company's income.
Please let me know if you need any clarification. I'm always happy to answer your questions.
The Dupont analysis over comes the problems associated the with current ratio, operating cash ratio, and quick ratio by factoring in all effects. Instead of just looking at liquid assets to determine a company's health, the Dupont analysis considers operating cash flow too.
The Dupont analysis tries to measure return on equity (ROE). Where
ROE = (Profit Margin)*(Total Asset Turnover)*(Equity Multiplier)
Notice ROE considers Operating Cash Flow, Assets, and Financial leverage. Not just one factor.
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