One defect of the current ratio is that it fails to convey any information on the composition of the current assets of a firm. A rupee of cash is considered equivalent to a rupee of inventory or receivables. But it is not so. A rupee of cash is more readily available (i.e. more liquid) to meet current obligations than a rupee of, say, inventory. This impairs the usefulness of the current ratio. The acid-test ratio is a measure of liquidity designed to overcome this defect of the current ratio. It is often referred to as quick ratio because it is a measurement of a firm‘s ability to convert its current assets quickly into cash in order to meet its current liabilities. Thus, it is a measure of quick or acid liquidity.
The acid-test ratio is the ratio between quick current assets and current liabilities and is calculated by dividing‘ the quick assets by t he current liabilities:
Acid-test ratio = Quick assets/Current liabilities
The term quick assets refers to current assets which can be converted into cash immediately or at a short notice without diminution of value. Included in this category of current assets are(i) cash and bank balances; (ii) short-term marketable securities and (Hi) debtors/receivables. Thus, the current assets, which are excluded, are prepaid expenses and inventory. The exclusion of inventory is based on the reasoning that it is not easily and readily convertible into cash. Prepaid expenses by their very nature are not available to payoff current debts. They merely reduce the amount of cash required in one period because of payment in a prior period.
The liquidity ratios discussed so far relate to the liquidity of a firm as a whole. Another way of examining the liquidity is to determine how quickly certain current assets are converted into cash. The ratios to measure these are referred to as turnover ratios. These are, as activity ratios, covered in detail later in this chapter. Here, we focus on them to supplement the three liquidity ratios discussed above. The three relevant turnover ratios are (i) inventory turnover ratio; (ii) debtors turnover ratio; and (iii) creditors turnover ratio.
Inventory Turnover Ratio It is computed by dividing the cost of goods sold by the average inventory. Thus, Cost of goods sold