In determining the short-term liquidity of a firm, the current ratio is usually

Question

In determining the short-term liquidity of a firm, the current ratio is usually considered a better guide than the acid-test ratio, and the acid-test ratio is considered a better guide than the cash ratio. Why do you think this is? Do you agree or disagree with the ranking of current ratio first, acid-test ratio second, and cash ratio third for short-term liquidity determination? Discuss when the acid-test ratio would be preferred over the current ratio and when the cash ratio would be preferred over the acid-test ratio.

Explanation / Answer

For calculating short term liquidity of firm. I dont agree with the ranking of current raio first, acid test ratio second and cash ratio third. In current ratio Current assets incukding stock is considered to check the liquidity of firm. Current ratio is current asset/current liabilities. Stock is also the part of current asset while calculating the current ratio.

However while calculating the acid test ratio, stock is excluded from the current ratio. So if the company has large part of its current assets as stock, acid test ratio will be less than its current ratio. So this type of firm will not be so much liquid as shown by its current ratio.

Further, The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover current liabilities. The cash ratio is the most stringent and conservative of the three short-term liquidity ratios (current, quick and cash). It only looks at the most liquid short-term assets of the company, which are those that can be most easily used to pay off current obligations. It also ignores inventory and receivables, as there are no assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities.

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