Calculation Formula | Examples | What Is "Good" | Analysis & Interpretation | Definition & Meaning
For example, some manufacturing companies hold large quantities of raw materials for the production of finished goods, which are then warehoused and sold on credit for a lengthy period of time.
In such businesses with slow inventory turnover and long cash cycle, stock is not a very liquid asset, compared to cash and other receivables.
Consequently, it would distort the ratio if inventory was used to assess short-term liquidity.
Instead, we calculate the quick ratio, which is the ratio of current assets less inventories to current liabilities.
The quick ratio is also known as the acid test ratio because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources to settle its liabilities.
A measure of 1:1 means that an entity is able to meet existing liabilities if they all fall due at once.
Some say that acceptable levels for the quick ratio range from 1:1 to 0.7:1.
But the absolute figures should only be used as a general guide.
In addition to analysing how ‘safe’ a business is based on the quick / acid test ratios alone, it is important to examine the figures in context, including the following considerations:
When it comes to the analysis and interpretation of the quick / acid test ratio, the comments are largely the same as for the current ratio.
Both the quick ratio and the current ratio offer an indication of a company’s short-term liquidity position and so both are calculated with formulas that are identical with only one–but significant–difference: in acid test ratio, inventory is removed from the current assets.
Consequently, the quick / acid test ratio offers the following advantages compared to the current ratio:
However, for business with normal speed of inventory turnover, where we do not want to exclude inventory from the calculation, use the current ratio instead.
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