CSLB Law & Business ExamBusiness FinancesMedium
A contractor is reviewing the company's financial health. The quick ratio (acid-test ratio) is calculated as (Current Assets - Inventory) ÷ Current Liabilities. What does a quick ratio of 0.8 indicate?
- AThe company has 80 cents in highly liquid assets for every dollar of current liabilities.
- BThe company can cover its operating expenses for 80 days without new revenue.
- CThe company's total assets are 80% higher than its total liabilities.
- DThe company has sufficient liquid assets to cover all long-term debts.
Show answer & explanationAnswer & explanation
Correct answer: A. The company has 80 cents in highly liquid assets for every dollar of current liabilities.
A quick ratio of 0.8 means that for every dollar of current liabilities, the company has 80 cents in highly liquid assets (current assets excluding inventory) available to cover those liabilities immediately. This indicates a potential liquidity concern.
Why the other options are wrong
- B. This relates to the cash conversion cycle or operating expense coverage, not directly the quick ratio.
- C. This describes a relationship between total assets and total liabilities, not specific to the quick ratio.
- D. The quick ratio assesses short-term liquidity, not long-term debt coverage.
Quick Ratio (Acid-Test Ratio)
A liquidity ratio that measures a company's ability to pay off its current liabilities with its most liquid assets (current assets minus inventory).
- Formula: (Current Assets - Inventory) / Current Liabilities.
- Excludes inventory because it's less liquid than cash or receivables.
- A ratio of 1.0 or higher is generally considered healthy, but varies by industry.
Memory trick: How quickly can you pay your bills? That's liquidity.