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Acid Test Ratio

Sometimes the current ratio does not really reflect the true or correct liquidity position. In interpreting the current ratio, it is necessary to study the composition of the current assets. This is done with the help of quick ratio which expresses the relationship of a company’s current assets that can be quickly converted into cash and its current liabilities. It is in fact the measure of the “Instant” debt paying ability of the business enterprise. A business with a large inventory that is not moving and with little cash and debtors may show as good a current ratio as one with large amount of cash, debtors and little stock in trade. In fact in many lines of a business, a company or a firm whose current assets consist largely of slow moving inventory can very easily become technically, if not actually, insolvent within short period of time. In these situations, liquid or acid-test or the quick ratio is the Quick ratio may be computed as follows:

Quick Ratio = Quick Assets / Current Liabilities

Components: Quick assets include cash in hand and those current assets which can be converted into cash either immediately or at a short notice without loss (or with negligible loss) such as cash at bank, debtors, short term loans, bills receivable, and investments in ready marketable securities. Stock in hand ( i.e. inventories) and prepaid expenses are not included in quick assets. In most situations, stock cannot be converted into cash. Prepaid expenses are also not convertible into cash; they simply reduce the demand for cash in the current accounting period because of advance payment made in the earlier period. The provision for bad and doubtful debts must be deducted from the total amount fo debtors in order to calculate the realizable value of debtors. The same considerations apply to bills receivable. Current liabilities include the same items which we take into consideration for current ratio.
Bank overdraft: This item is a  part of current liabilities. However some accountants are of t he view that in normal circumstances, bank overdraft facility is not withdrawn by the banks all of a sudden. In fact bank overdraft has become a method of financing activities. It is therefore suggested that for the purpose of quick ratio, bank overdraft should not be included in the list of current liabilities. If this suggestions accepted,  the quick ratio should be calculated as:

Quick Assets / Quick Liabilities

Quick liabilities would not include the bank overdraft. It is sincerely hoped that examiners will take care f the interest of the students by clearly indicating whether the overdraft facility is permanent one or just short-term one like other current liabilities.

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