378 CHAPTER 10 Analysis of Financial Statements
Quick, or Acid Test, Ratio
The quick,or acid test, ratiois calculated by deducting inventories from current as-
sets and then dividing the remainder by current liabilities:
Inventories are typically the least liquid of a firm’s current assets, hence they are the
current assets on which losses are most likely to occur in a bankruptcy. Therefore, a
measure of the firm’s ability to pay off short-term obligations without relying on the
sale of inventories is important.
The industry average quick ratio is 2.1, so MicroDrive’s 1.2 ratio is low in compar-
ison with other firms in its industry. Still, if the accounts receivable can be collected,
the company can pay off its current liabilities without having to liquidate its inventory.
Identify two ratios that are used to analyze a firm’s liquidity position, and write
out their equations.
What are the characteristics of a liquid asset? Give some examples.
Which current asset is typically the least liquid?
Asset Management Ratios
Thesecondgroupofratios,theasset management ratios,measurehoweffectivelythe
firmismanagingitsassets.Theseratiosaredesignedtoanswerthisquestion:Doesthe
totalamountofeachtypeofassetasreportedonthebalancesheetseemreasonable,too
high,ortoolowinviewofcurrentandprojectedsaleslevels?Ifacompanyhasexcessive
investments in assets, then its operating assets and capital will be unduly high, which
will reduce its free cash flow and its stock price. On the other hand, if a company does
nothaveenoughassets,itwilllosesales,whichwillhurtprofitability,freecashflow,and
the stock price. Therefore, it is important to have therightamount invested in assets.
Ratiosthatanalyzethedifferenttypesofassetsaredescribedinthissection.
Evaluating Inventories: The Inventory Turnover Ratio
The inventory turnover ratiois defined as sales divided by inventories:
As a rough approximation, each item of MicroDrive’s inventory is sold out and re-
stocked, or “turned over,” 4.9 times per year. “Turnover” is a term that originated
many years ago with the old Yankee peddler, who would load up his wagon with
goods,thengoofftopeddlehiswares.Themerchandisewascalled“workingcapital”
becauseitwaswhatheactuallysold,or“turnedover,”toproducehisprofits,whereas
Industry average9.0 times.
$3,000
$615
4.9 times.
Inventory turnover ratio
Sales
Inventories
Industry average2.1 times.
$385
$310
1.2 times.
Quick, or acid test, ratio
Current assetsInventories
Current liabilities
374 Analysis of Financial Statements
