Page 161 - CalcBus_Flipbook

CH 20] Calculating Business 20-5

Quick Assets
Acid-Test Ratio = —————————
Current Liabilities

This is an important supplement to the current ratio because it indicates the company's
ability to meet current obligations. When the quick assets are less than current liabilities, the
company may experience difficulty in converting the non-quick assets if it must do so to meet
current debts. A ratio of 1:1 is considered to be the minimum.
Quick assets would include Cash, Cash Equivalents, Short Term Investments and Accounts
receivables. As such the Acid-Test Ratio becomes
Cash + Cash Equivalents + Short Term Investments + Current Receivables
Acid-Test Ratio = —————————————————————————————————————
Current Liabilities 20

Although there is no definite standard, an acid-test ratio in excess of 1:1 is usually
considered to be satisfactory. Short term
Example A: Dunbar is applying for a loan with his local bank to expand his business. The investment:
bank asks for a balance sheet, Figure 20.1, to analyze his current debt levels. His Usually an
balance sheet reports $18,000 cash and $32,400 accounts receivable. His current investment of 5
years or shorter.
liabilities are $15,820. (a) What is Dunbar’s Acid-Test ratio, and (b) is this sufficient The returns
to satisfy the banks desired ratio of 1:1? should easily
convert to cash
Solution algorithm: when the time is

Cash + Cash Equivalents + Short Term Investments + Current Receivables right. Examples
Acid-Test Ratio = ————————————————————————————————————- of short term
Current Liabilities
investments are
$18,000 + 0 + $32,400 + 0 high-yield
(a) Acid-Test Ratio = ————————————— = 3.19:1 savings
$ 15,820 accounts,
Certificates of
(b) Yes, the Dunbar ratio exceeds the desired minimum ratio for the bank of 1:1.
Deposit, money
Inventories of raw materials, work in process, and finished goods (or merchandise) often market accounts,
represent a large portion of total current assets. A considerable amount of time may be required treasury bills,
and government
to convert inventories into cash in the normal operating processes. There is also the possibility of bonds.
declines in market prices and a reduction in demand, both of which will adversely affect the
ability to pay current liabilities. The acid-test ratio gives recognition of these factors.
Sometimes company financial statements don’t give a breakdown of quick assets on
the balance sheet. In this case the quick ratio is used even if some of the quick asset totals are
unknown. Simply subtract inventory and any current prepaid assets from the current asset total
for the numerator. The equation is:

Total Current Assets – Inventory – Prepaid Expenses
Quick Ratio (Acid Test Ratio) = ——————————————————————————
Current Liabilities

Using the Dunbar Company Balance Sheet information from Figure 20.1, the quick ratio is
calculated as:

$101,400 – $48,000 – $3,000 $50,400
Quick Ratio = ——————————————— = ———— = 3.19 : 1
$15,820 $15,820

Example B: The Smart Shoppe is applying for a loan to complete some store remodeling. The
bank asks for their most recent balance sheet to calculate the quick ratio. (a) What
is Smart Shoppe’s Quick Ratio, and (b) and is it sufficient to satisfy the banks
desired ratio of 1:1? The Smart Shoppe included the following accounts:

Cash: $20,000
Accounts Receivable: $12,000
Inventory: $11,000
Stock Investments: $ 2,000
Prepaid Taxes $ 1,000
Current Liabilities: $30,000

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