Strategic Planning in the Small Business

Unit 2 HO 2-5 (continued)

very strong. In fact, the firm should

now consider some more

productive use of cash and/or some distribution

of cash as div­

idends to stockholders.

Acid Test Ratio The acid test ratio is computed

by dividing the

sum

of cash, receivables and marketable securities by current

liabilities. (In our

example, cash plus receivables are divided

by current

liabilities.) Since inventories may not be easily con­

verted to cash, this ratio gives a more accurate

picture of the

firms' capacity for short-run response

to opportunities and crises

by subtracting out the value of these inventories.

Although

considerable variability

is present, an acid test of one-to-one is

typically sought. Table 2-7 shows the Acid Test

Ratios for Wav­

erly Custom Jewelers.

Table 2-7 Comparative

Acid Test Ratios

Cash

&Receivables

Current

Liabilities

Year 4 Year 3 Year 2

Year 1

(41,300 + 98,400) (41,906 + 83,300) (17,800 + 64,000) (16,200 + 48,600)

49,000 67,000 84,800

93,700

2.9 to 1 1.9 to I I to 1

.7 to I

Activity

Ratios

Once liquidity ratios have been

considered, a series of activity

ratios may be examined. These ratios offer insight into how

effectively the firm is

using its resources.

Inventory Turnover Inventory turnover is computed

by divid­

ing cost of goods sold by average

inven:ory. Again, because

rules of thumb vary depending on industry, it is valuable to

compare the figures to the industry, as well as past historical

trends. The historical

trend for the sample company (Table

2-8) presents some difficulty

in interpretation. Higher inven­

tory

turnover rates are desirable, yet lower ratios appear in the

67

Chapter Two Internal

Analysis

210