CSLB Contractor's Law & Business Practice Exam

Which financial ratio measures liquidity?

1. Gross profit margin

2. Return on equity

3. Both the current ratio and acid-test ratio

4. Debt to equity ratio

The correct answer is: Both the current ratio and acid-test ratio

The measure of liquidity is primarily concerned with a company's ability to meet its short-term obligations. The current ratio and acid-test ratio are both financial metrics specifically designed to evaluate liquidity. The current ratio is calculated by dividing current assets by current liabilities, providing a snapshot of whether the business has enough resources to cover its immediate debts. A ratio greater than one typically indicates that the company can comfortably meet its short-term obligations. The acid-test ratio, also known as the quick ratio, refines this evaluation of liquidity by excluding inventory from current assets. This is crucial because inventory may not be as easily converted into cash in the short term compared to other current assets. A higher acid-test ratio signifies stronger liquidity, indicating that the entity can meet its short-term liabilities even if it cannot sell its inventory quickly. In contrast, the other financial ratios listed, such as gross profit margin, return on equity, and debt to equity ratio, serve different purposes. Gross profit margin measures profitability, return on equity examines overall profitability relative to shareholders' equity, and the debt to equity ratio addresses the company’s capital structure, reflecting its leverage. These metrics do not specifically assess the ability to meet short-term liabilities, which is why the current ratio and acid-test ratio stand out as