Firm B demonstrates the greatest capacity to pay. Firm B has the highest acid-test ratio, highest interest coverage ratio, and lowest capitalization (debt) ratio. The acid-test ratio is the current assets minus inventory divided by the firm’s current liabilities. A higher acid-test ratio indicates greater capacity to pay principal and interest. The interest coverage ratio is typically computed as earnings before interest and taxes (EBIT) divided by annual interest expense. A higher interest coverage ratio indicates greater capacity to pay principal and interest. Lower levels of debt (i.e. lower capitalization ratios) also indicate greater capacity to pay. |
