Assets that are easily and quickly convertible to cash are called quick assets.
Examples of quick assets are cash equivalents, accounts receivable, and marketable securities.
Inventory and prepaid items are not quick assets and are not included in the quick ratio calculation.(Current Assets – Inventory – Prepaid Expenses)/Current Liabilities
Though inventory is a current asset, it is more difficult to liquidate, and values more difficult to determine. Products no longer in demand are often liquidated at steep discounts, which often occur in the retail industry during seasonal changes.
The acid test is therefore an even more stringent measure of liquidity by excluding those assets like inventory that are not quickly convertible to cash.
A ratio of 1.5 or greater is considered adequate to cover short-term debts, and a ratio of less than one is a clear warning signal that a company may not be able to pay its short-term debts.
Industry standards should always be considered when comparing financial ratios. For example, companies in cyclical industries may require higher ratios to remain solvent during downturns.
The below table show the ratios for the Software Industry, Sunny Sunglasses Shop’s main competitor, Luxottica Group, the industry average (Specialty Retail, Other), and the S&P 500.Sunglasses Hut Int. (Luxottica Group)
Industry ratios can be found at MSN Money under Financial Results: Key Ratios, and Yahoo Finance under Company: Competitors.
Notice that Microsoft and the software industry have the same current ratios and quick ratios, which indicates that software companies have very low inventory levels compared to other assets. The software industry has the advantage of maintaining low inventory levels since software is easily reproduced.
Microsoft was known for hoarding cash, up to $40 billion, that resulted in an acid test of four. Because ratios that are too high may indicate inefficiency in utilizing assets, investors wanted to know what Microsoft planned on doing with the cash, whether pouring it into R&D for emerging products and markets, or paying dividends back to investors. Microsoft began paying dividends for the first time in its history in January of 2003.
According to Microsoft, the company had decided to pay a dividend due to Microsoft’s continued growth during the downturn, as well as the resolution of several legal cases that meant Microsoft would not have to reserve as much cash to pay for legal costs. Both the current ratio and the acid test returned to industry averages with the annual distribution of cash in the form of dividends.
Sunny Sunglasses Shop’s financial ratios are substantially higher than its competitor and industry averages, which may indicate assets are underutilized. To view the balance sheet analysis example, click balance sheet analysis.