Which ratios measure a corporation’s liquidity? What are some of the problems associated with using financial ratios? How would the Dupont analysis overcome some of these problems?

·         Which ratios measure a corporation’s liquidity? What are some of the problems associated with using financial ratios? How would the Dupont analysis overcome some of these problems?

Commonly used ratios that measure a firm's liquidity include the current ratio and quick ratio. There are several problems when using these ratios. First, the ratios cannot be analyzed in isolation. For example, the common rule of thumb for the current ratio is that it should be close to two to be considered healthy. However, that is not always the case. Different industries have different standards, and the ratio should be compared to the sector average instead of two. Another problem with these ratios is that their values can be made to appear better by end-of-year transactions. For example, a firm can bolster its liquidity ratio by using cash to pay off short-term liabilities. Ratios can be difficult to compare because of firms' use of different accounting practices. For example, during an inflationary period, a firm using LIFO inventory management can have an understated liquidity ratio since the value of inventory is also understated. Decomposing return on equity into various factors is called DuPont analysis. Use of the DuPont analysis gives a better understanding of the firm's strengths and weaknesses. The various components' relationship to ROE can help pinpoint the causes of a firm's weaknesses while simple ratios cannot.