ACCA Performance Management (F5) Certification Practice Exam

Which of the following ratios is essential for measuring liquidity?

1. Current ratio

2. Solvency ratio

3. Profit margin

4. Return on equity

The correct answer is: Current ratio

The current ratio is vital for measuring liquidity as it assesses a company's ability to meet its short-term obligations with its short-term assets. This ratio is calculated by dividing current assets by current liabilities. A higher current ratio indicates that the company has more current assets available to cover its current liabilities, which is essential for understanding the firm’s financial health in the short term. Liquidity is critical for businesses to ensure they can pay off immediate debts and operational expenses without having to liquidate long-term assets. A ratio typically greater than 1 suggests that the company has a good short-term financial strength, thus avoiding potential cash flow issues. In contrast, the other ratios focus on different aspects of a company’s financial performance. The solvency ratio measures long-term financial stability and the ability to meet long-term debts rather than immediate obligations. Profit margin relates to profitability by indicating how much of the revenue is converted into profits, whereas return on equity measures profitability relative to shareholders' equity. These metrics are important for overall financial assessment but do not specifically address liquidity.