Question

A tutorial question and its suggested solution was:

The current and quick (acid test) ratios are both measures of what? Which of the two ratios is a stricter test, and how does it accomplish this?

Solution: These are liquidity ratios—assessments of how well the business can meet short-term commitments or claims against the assets when they fall due. These ratios are sometimes expressed in terms of the ability or speed with which assets can be converted to cash.

The acid test is the more stringent of these two ratios. It does this by not including inventory or prepayments as assets that can readily be turned into cash.

Required:

In your own words, explain (i) why liquidity analysis of a company is important and (ii) why inventory and/or prepayments are excluded in the calculation of the acid test ratio.

Answer 1

Firstly what is liquidity? Liquidity in it's technical definition means owing things that can be exchanged for cash.

Now talking about liquidity analysis it is important to know about the ability of a company current assets and their power to meet the short term obligations of the company. Liquidity Analysis is important because it is a measure the short term debtt paying abilities of the company that are basically the daily expenses.Liquid is all about daily income and expenses. For liquidity analysis current and quick ratio are calculated to find out the proportion of their assets to their Liablities. Usually these ratios are very important for the stakeholders like Creditors, Management etc.They are interested in it to find out the position of the company and whether to extend what type of credit policies to the company.It is also important from management point of view to decide whether the current working capital will be enough or there will be external.or long term financing is required. In a nutshell Liquidity Analysis is important cfrom various point of views and to ensure the company ability to maintain their short term solvency.

2 . Inventories and Prepaid Expenses are excluded while calculating acid test ratio because the acid test ratio is the measure of the ability of company liquid assets means the assets which is readily convertible into cash. For prepaid expenses there will be no cash conversion instead they are paid in advance for their usage over the future period of time.Similarly in case of stocks.there is no specified time for it's conversion into cash. For example company need cash currently it can not sell it's stock immediately to realize cash whereas assets like Cash, Short Term Securities can be readily convertible into cash as and when company required moreover accounts receivable that are recoverable in short term are considered relevant from.the point of view of acid test ratio. Due to unavailability of feature of instant conversion inventory and prepaid expenses are excluded in calculation of acid test ratio.