FIN 370/Finance for Business/ Week 1 DQ 3

What ratios measure a corporations liquidity? What are some problems associated with using such
rations? How would the DuPont analysis overcome these problems?
The current ratio uses current assets divided by current liabilities to estimate a company's relative
liquidity. By excluding inventories a company can find its liquidity quicker with an acid-test ratio which takes
current assets minus inventories divided by the current liabilities. Finding how long it takes the firm to
collect receivables you can use an average collection period ratio. Also the inventory turnover ratio and
accounts receivable are second views of liquidity. To find out the liquidity of inventory one would use the
inventory turnover ratio that takes the cost of goods sold divided by the inventory. The ratios I have
explained can all measure a form of a corporations liquidity.
Some of the problems associated with using these ratios are: that it is sometimes difficult to identify the
industry category to which a firm belongs when the firm engages in multiple lines of business, Published
industry averages are only approximations and provide the user with general guidelines rather than
scientifically determined averages of the ratios, Accounting practices differ widely among firms and can
lead to differences in computed ratios, the liquidity of a firms receivables and inventories can be misleading
if the firms sales are seasonal because the balance sheet entries and their corresponding ratios will vary
with the time of year when the statements are prepared.
DuPont analysis can help overcome some of these problems by allowing management to see more clearly
what drives the return on equity and the interrelationships among the net profit margin, the asset turnover,
and the debt ratio. By using the DuPont analysis management is provided can determining its
effectiveness in managing the firms resources to maximize the return earned on the owners investment.
Also, the manager or owner can then determine why that particular return was earned.
Prentice Hall. Copyright 2005 by Pearson Education, Inc.
Financial Management: Principles and Applications, Tenth Edition by Arthur J. Keown, John D. Martin, J.
William Petty, and David F. Scott, Jr. Published by Pearson