Question

In determining the short-term liquidity of a firm, the current ratio is usually considered to be a better guide than the acid-test ratio, and the acid-test ratio is considered to be a better guide than the cash ratio. Discuss when the acid-test ratio would be preferred over the current ratio, and when the cash ratio would be preferred over the acid-test ratio.

Answer 1

Ans. Both current ratio and acid test ratio are liquidity ratio that measures company ability to pay-off short term liability with short term assets.

Acid -test Ratio :- The quick ratio offers a more conservative view of a company liquidity or ability to meet its short-term liability with its short term assets because it does't include inventory and other current assets that are more diffcult to liquidity (i.e. turn into cash). By exluding inventory and less liquidity assets, the quick ratio focuse on the company more liquid assets.

Since the current ratio include inventory, it will be high for companies that are heavily involved in selling inventory.

When acid test ratio preferred over the current ratio: - when are the company having very short term liability those are payable within the 90 days then we will see acid test ratio under the acid test ratio we will take the short term assets which are mature within the 90days.

Cash Ratio: cash ratio is also another measurement of a company liaquidity and their ability to meet their short term obiligation, formula of cash ratio (cash+marketable securities/current liability)

When cash ratio be preferred ove the acid test ratio : In this ratio we will exclude account receivable and inventory and we are using cash and marketable securities. The cash ratio must like an indicator of a firm's value under the worst case scenario when the company is about to go out of business.this ratio tells creditors analysts the value of current assets that could be quickly be turned into cash and what percentage of the company current assets liabilities these cash and near cash assets could over.

cash ratio preferred acid test ratio because it will determine immediate fund value of firm from which firm can pay his own very short term liability.