Chapter 4 Analysis of Financial Statements 89turn into bad debts. Or the high current ratio might indicate that the! rm has too
much cash, receivables, and inventory relative to its sales, in which case these assets
are not being managed ef! ciently. So it is always necessary to look deeply into the
full set of ratios before forming a judgment as to how well the! rm is performing.4-2b Quick, or Acid Test, Ratio
The second liquidity ratio is the quick, or acid test, ratio, which is calculated by
deducting inventories from current assets and then dividing the remainder by cur-
rent liabilities:Quick, or acid test, ratio! Curr_________________________ent assets # Inventories
Current liabilities! $385_____
$310
! 1.2"Industry average! 2.2"Inventories are typically the least liquid of a! rm’s current assets; and if sales slow
down, they might not be converted to cash as quickly as expected. Also, invento-
ries are the assets on which losses are most likely to occur in the event of liquida-
tion. Therefore, the quick ratio, which measures the! rm’s ability to pay off short-
term obligations without relying on the sale of inventories, is important.
The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is relatively low.
Still, if the accounts receivable can be collected, the company can pay off its current
liabilities even if it has trouble disposing of its inventories.Quick (Acid Test) Ratio
This ratio is calculated by
deducting inventories
from current assets and
then dividing the
remainder by current
liabilities.Quick (Acid Test) Ratio
This ratio is calculated by
deducting inventories
from current assets and
then dividing the
remainder by current
liabilities.4-3 ASSET MANAGEMENT RATIOS
The second group of ratios, the asset management ratios, measure how effectively
the! rm is managing its assets. These ratios answer this question: Does the amount
of each type of asset seem reasonable, too high, or too low in view of current and
projected sales? These ratios are important because when Allied and other compa-
nies acquire assets, they must obtain capital from banks or other sources and capital
is expensive. Therefore, if Allied has too many assets, its cost of capital will be too4-3 Asset Management Ratios
Ratios
A set of ratios that
measure how effectively
a firm is managing its
assets.Asset Management
Ratios
A set of ratios that
measure how effectively
a firm is managing its
assets.SELF^ TEST What are the characteristics of a liquid asset? Give examples of some liquid
assets.
What question are the two liquidity ratios designed to answer?
Which is the least liquid of the! rm’s current assets?
A company has current liabilities of $500 million, and its current ratio is
2.0. What is the total of its current assets? ($1,000 million) If this! rm’s quick
ratio is 1.6, how much inventory does it have? ($200 million) (Hint: To an-
swer this problem and some of the other problems in this chapter, write out
the equation for the ratio in the question, insert the given data, and solve for
the missing value.)
Examples:
Current ratio! 2.0! CA/CL! CA/$500, so CA! 2($500)! $1,000
Quick ratio! 1.6! (CA " Inventories)/CL! ($1,000 " Inventories)/$500, so
$1,000 " Inventories! 1.6($500) and Inventories! $1,000 " $800! $200