To evaluate a firm’s capacity to meet its short-term obligations, which financial ratio is most appropriate?

The most appropriate financial ratio to evaluate a firm's capacity to meet its short-term obligations is the quick ratio. This ratio assesses the company’s ability to cover its current liabilities with its most liquid assets, excluding inventory. The quick ratio provides a more stringent test of liquidity than the current ratio, as it focuses on assets that can readily be converted into cash.

The quick ratio is significant for creditors and investors who want to understand the firm’s immediate financial health. A higher quick ratio indicates that the company has sufficient liquid assets to cover its short-term liabilities, thus reflecting a stronger liquidity position. It is particularly useful in industries where inventory may not be quickly liquidated to address immediate financial needs.

In contrast, while the current ratio also assesses liquidity by comparing current assets to current liabilities, it includes inventory in the asset calculations, which may not always be easily converted to cash in the short term. The debt ratio measures long-term financial leverage, and return on equity is a profitability measure rather than a liquidity metric. Therefore, for evaluating short-term financial obligations, the quick ratio is the most relevant criterion.