Calculate & analyze current ratios and acid test
Financial ratios are an integral part of any business, which help to quantify various aspects of company’s operations and performance. When making a decision on the loan, creditors usually consider liquidity ratios in their analysis. Such ratios help to understand whether the company is able to repay its debt by converting its short-term non-cash assets into cash. The higher liquidity ratios are, the safer it is to give loans to this company. Current ratio and acid-test ratio are among the most commonly used ratios for liquidity analysis. Current ratio can be calculated as a ratio of current assets to current liabilities. Thus, for Thingamajigs and things it is equal to $45000/$9000 = 5. For WannaBeess the current ratio is $150000/$85000 = 1.76. As both of the ratios are above 1, both Thingamajigs and things and WannaBeess will be able to repay the loan, therefore they can both get it. However, since 5 is greater than 1.76, Thingamajigs and things is more likely to get the loan, as higher current ratio indicates a stronger ability to repay obligations. Acid-test ratio, also known as quick ratio, evaluates company’s ability to pay its debt in a more stringent way than current ratio. In the calculation of the acid-test ratio, inventory is not considered liquid enough, therefore it is subtracted from the current assets. Thus, for Thingamajigs the acid-test ratio is ($45,000-$30,000)/$9,000 =1.67. In the case of WannaBeess it is ($150,000-$125,000)/$85,000 =0.29. As the companies with the acid-test ratio below 1 are not able to repay their obligations, WannaBeess is not going to get the loan. Therefore, if the decision is based on the acid-test ratio, only Thingamajigs and things is going to receive the loan.
The difference in conclusions, drawn from the current and acid-test ratios, arises from the fact that inventory is not considered in the acid-test ratio. WannaBeess store has a lot of assets tied-up in inventory. Low liquidity of inventory makes it difficult for the store to repay its short-term debts, thus creditors will be careful in providing loans to such a company.
