Question

4 - case study: analyzing accounting statements
learning objective: examine how to use ratio analysis in financial statements.
a bank is assessing a small business loan application, noting the applicants current ratio of 0.7.
what does this ratio imply?
a.) the low ratio indicates a possible liquidity risk, so lending should be reevaluated.
b.) the business is very profitable and can readily repay the loan.
c.) the company has no liabilities and remains in strong financial health.
d.) the ratio indicates the company has sufficient assets to meet its obligations.

Explanation:

Define current ratio

Using the Financial Statement Analysis knowledge point
The current ratio measures short-term liquidity:

$$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} $$

Analyze the given value

A current ratio of \(0.7\) means current assets are less than current liabilities:

$$ \text{Current Assets} = 0.7 \times \text{Current Liabilities} $$

Evaluate liquidity risk

Since the ratio is less than \(1.0\), short-term obligations exceed short-term assets. This indicates a potential liquidity risk.

Assess the options

• Option (a) correctly identifies liquidity risk.
• Option (b) confuses liquidity with profitability.
• Option (c) is incorrect because liabilities exist.
• Option (d) is incorrect because assets are insufficient.

Answer:

• a.) The low ratio indicates a possible liquidity risk, so lending should be reevaluated. (Correct answer)
• b.) The business is very profitable and can readily repay the loan.
• c.) The company has no liabilities and remains in strong financial health.
• d.) The ratio indicates the company has sufficient assets to meet its obligations.