Question

Why are inventories and prepaid expenses excluded in computing the acid-test ratio?

Answer 1

Ans.

Acid test ratio is also known as Quick Ratio which is calculated by dividing Quick assets and Current Liabilities.This is a liquidity ratio which indicates the company's ability to meet its short term obligation.

Now the Quick assets are those current assets which can easily be converted into cash. While calculating Quick Assets we exclude inventories and prepaid Expenses.

The reason of excluding Inventories and Prepaid Expenses is as follows:

Inventories are excluded while calculating acid test ratio because it will take longer time to realize cash from Inventories or we can say that although Inventories are current asset but they can not be easily converted into cash and (easily means within a shorter period of time).

Prepaid Expenses are the expenses whose payment is made in advance and treated as current assets because the liability to pay these expenses is arise in future and the payment related to which made in advance. These expenses are excluded while calculating acid test ratio because this asset can not be used to meet our current liabilities or we can say that although prepaid expenses are treated as current asset but we can not make repayment of current liabilities arises in future from this asset as we can do from others like cash, cash equivalents ,current receivables etc.

So,while calculating acid test ratio we will exclude inventories and prepaid expenses from current assets.