receivables and the type and quantity of inventory the firm carries. Public
utilities and railroad companies often have a current ratio of 1 to 1 or be-
low.^2 In an electric utility company, for example, the low current ratio is
possible because of its minimum inventory requirements and the stability
of its revenues and cash flow.
Acid Test The acid test, or quick ratio, is obtained by dividing current lia-
bilities into the firm’s net receivables and cash. This ratio highlights the
firm’s short-term liquidity position. One prefers a higher acid test ratio.
The rule-of-thumb measure of a satisfactory acid test ratio is 1 to 1; that is,
an acid test ratio of 1 indicates that the firm could turn all current assets,
with the exception of inventory, into cash and pay off its current liabilities.
From an obverse point of view, the acid test ratio tends to indicate the
amount of inventory in the working capital position of the firm. For exam-
ple, if the current ratio is 3 to 1 and the acid test is only .85 to 1, the inven-
tory account probably constitutes a heavy proportion of the current assets.
A corporation’s inventory may not be as valuable as the initial value of the
finished goods, such as in the case of older computers.
Leverage Ratio
The current analysis ratios are most important to credit managers who
pass on credit sales and others who are interested in the firm’s short-term
position. The leverage ratios are useful to investors, long-term creditors,
and others concerned with the firm from a longer-term basis. Of course, in
any case, whether the analyst’s interest is short- or long-term, selections of
pertinent ratios should be made from both groups.
Short-term creditors have sometimes lent (given) a firm funds on the
basis of a good current position, unwisely ignoring other fundamental fi-
nancial analysis. For although the first grant of credit might be repaid on
time, many short-term arrangements turn out to be semipermanent as the
supplier periodically renews or extends new credit to the customer firm. If
fundamental financial weaknesses outside the current position are passed
over, they may cause failure at some later date with consequent losses to
the supposedly short-term creditor. In essence, leverage ratios tell the in-
vestor what a corporation owes its creditors.
Total Debt to Assets The total debt to total assets ratio, discussed in the
previous chapter with respect to Johnson & Johnson (JNJ), helps investors
and creditors assess the riskiness of the firm. One prefers a lower total debt
to total assets ratio.