FAR · Financial reporting · 8 practice questions
How to Calculate the Quick Ratio (Acid-Test Ratio)
The quick ratio compares unrestricted cash, cash equivalents, short-term marketable securities, and net trade receivables with all current liabilities. Below: a worked calculation shows what to include and what to leave out.
Try one first
Hint
Focus on which current assets are truly quick assets and whether the liability is due within one year.
Answer D. The quick ratio uses quick assets, cash, readily marketable short-term securities, and net receivables, in the numerator and compares them to current liabilities. Inventory and prepaid items are excluded because they are not readily convertible to cash. Current liabilities include amounts due within one year, so accrued liabilities and the current portion of long-term debt are included in the denominator.
Why not A: Excluding accrued liabilities because they are 'estimates' is incorrect, accrued liabilities are still current liabilities and must be included; also, readily marketable short-term trading securities are quick assets and should be included in the numerator.
Why not B: This is tempting because inventory is a current asset, but the quick ratio specifically excludes inventory; also, the denominator is not limited to 'operating' liabilities, it includes all current liabilities due within one year.
Why not C: Prepaid insurance is a current asset but not a quick asset because it cannot be readily converted to cash; the current portion of long-term debt is a current liability and must be included.
Worked example
At year-end, Elm Co. has cash of $65,000, including $15,000 restricted for long-term plant expansion; readily marketable short-term securities of $25,000; net trade receivables of $125,000; inventory of $95,000; and prepaid insurance of $5,000. Its only current liabilities are accounts payable of $85,000, accrued liabilities of $35,000, and current maturities of long-term debt of $40,000. Compute its quick ratio.
| 1 | Remove restricted cash$65,000 - $15,000 | $50,000 unrestricted cash |
| 2 | Exclude inventory and prepaids$95,000 + $5,000 | $100,000 excluded |
| 3 | Add quick assets$50,000 + $25,000 + $125,000 | $200,000 |
| 4 | Add all current liabilities$85,000 + $35,000 + $40,000 | $160,000 |
| 5 | Divide quick assets by current liabilities$200,000 ÷ $160,000 | 1.25 |
Elm's quick ratio is 1.25 to 1: $1.25 of quick assets for each $1 of current liabilities.
Check: Quick assets exceed current liabilities by $40,000, one-quarter of $160,000, so the ratio is 1 + 0.25 = 1.25.
Key points
- Use receivables net of the allowance. If the balance is already net, do not subtract the allowance again.
- Use balances at the measurement date, not annual averages.
- A ratio below 1.0 means quick assets are less than current liabilities.
- For a covenant, follow its stated quick-asset definition and required testing date.
How the exam traps you
- Counting every current asset as a quick asset. Include unrestricted cash, cash equivalents, readily marketable short-term securities, and net receivables. Exclude inventory and prepaids.
- Counting cash restricted for long-term use because it is labeled cash. Remove long-term restricted cash. It is unavailable to pay current obligations.
- Using only operating current liabilities in the denominator. Include accounts payable, accrued liabilities, short-term notes, and current maturities of long-term debt.
Question 2
| Financial Item | Amount |
|---|---|
| cash | $50,000 |
| marketable securities | $30,000 |
| net accounts receivable | $70,000 |
| inventory | $100,000 |
| prepaid insurance | $20,000 |
Hint
Focus on which current assets are available to pay near-term obligations without selling inventory or waiting to benefit from a prepaid item.
Answer A. Quick assets include cash, marketable securities, and net accounts receivable, but exclude inventory and prepaid items. Quick assets = $50,000 + $30,000 + $70,000 = $150,000; divided by current liabilities of $150,000 yields a quick ratio of 1.00.
Why not B: This results if a candidate excludes marketable securities and uses only cash and receivables: $50,000 + $70,000 = $120,000; 120,000 / 150,000 = 0.80. Marketable securities are typically included as quick assets because they are highly liquid.
Why not C: This comes from subtracting inventory from total current assets but leaving prepaid insurance in the numerator: total current assets $270,000 − inventory $100,000 = $170,000; 170,000 / 150,000 = 1.13. Prepaid insurance is not a quick asset.
Why not D: This is the current ratio using all current assets: $270,000 / $150,000 = 1.80. The quick ratio excludes inventory and prepaid items, so it is lower.
Question 3
Hint
Focus on the ratio category first: the lender wants short-term liquidity, and the stem tells you inventory should not be counted.
Answer A. The quick ratio (acid-test ratio) is a liquidity measure that focuses on the most liquid current assets, typically cash, marketable securities, and receivables, relative to current liabilities and excludes inventory. Because the lender specifically asked that inventory not be counted due to slow-moving stock, the quick ratio best matches the stated concern about near-term ability to pay obligations. It therefore is the most relevant liquidity metric in this fact pattern.
Why not B: Inventory turnover is tempting because the stem mentions slow-moving inventory, but it is an activity/efficiency ratio showing how quickly inventory is sold, not a direct measure of short-term liquidity available to meet current liabilities.
Why not C: Debt-to-equity measures leverage and long-term solvency rather than immediate liquidity; it does not isolate liquid current assets available to cover near-term obligations, so it does not address the lender's short-term liquidity concern.
Why not D: Gross profit percentage is a profitability metric that reflects margin on sales, not a liquidity ratio; while profitability affects cash generation over time, it does not directly measure the firm's ability to pay current obligations without counting inventory.
Question 4
Hint
Focus on the ratio that tests short-term liquidity after removing less-liquid current assets from the numerator.
Answer C. The quick ratio is the best metric because it focuses on the most liquid assets available to satisfy current liabilities and excludes inventory. That makes it especially useful when the user's concern is whether short-term obligations can be met without depending on inventory sales. In this fact pattern, that directly matches the lender's primary issue.
Why not A: This is tempting because slow-moving inventory is part of the lender's concern, and inventory turnover helps assess how efficiently inventory is sold. But it does not directly measure whether liquid assets are sufficient to cover current liabilities; it addresses inventory efficiency, not immediate liquidity coverage.
Why not B: This is tempting because the current ratio is also a liquidity measure. However, it includes inventory in current assets, so it does not isolate the company's ability to pay current liabilities without relying on inventory. That is exactly the limitation the lender is worried about.
Why not D: This choice may attract candidates who connect inventory with product profitability. However, gross profit margin measures profitability on sales, not short-term liquidity. A company can have a strong margin and still have weak liquid resources to pay current obligations.
Question 5
Hint
Before comparing the result to the covenant, decide which current assets belong in the quick ratio numerator and which do not.
Answer C. Quick assets for the quick ratio are cash, marketable securities, and net accounts receivable. Those total $20,000 + $20,000 + $50,000 = $90,000; divided by current liabilities of $100,000 gives a quick ratio of 0.90. Because the covenant requires a minimum of 1.0, North does not comply.
Why not A: This confuses the quick ratio requirement with the current ratio. Current assets include inventory and prepaid items, which are excluded from the quick ratio numerator, so having current assets exceed current liabilities does not guarantee compliance with a quick-ratio covenant.
Why not B: This result comes from incorrectly including inventory in the numerator (cash + marketable securities + receivables + inventory = $160,000). Inventory is not a quick asset, so including it overstates the quick ratio.
Why not D: This confuses the quick ratio with the cash ratio. Net accounts receivable are considered quick assets and must be included in the quick ratio numerator, so excluding them understates the ratio.
Question 6
Hint
Look for the liquidity ratio that intentionally removes assets that may not be quickly turned into cash.
Answer D. The quick ratio is the stricter liquidity measure because it focuses on assets that are generally available in the near term to satisfy current obligations, such as cash, cash equivalents, short-term investments, and receivables. It excludes inventory and prepaid expenses, which matches the bank's concern in the fact pattern. That makes it the best classified measure of immediate liquidity here.
Why not A: Lenders do care about leverage, so this can distract, but debt-to-equity is a solvency/leverage ratio concerned with capital structure, not an immediate liquidity measure of the most liquid current assets.
Why not B: Tempting because it is a liquidity ratio, but the current ratio includes all current assets (including inventory and prepaid expenses), so it is not the stricter, most-liquid-only measure the bank requested.
Why not C: This seems attractive since inventory is mentioned, but inventory turnover is an activity/efficiency ratio showing how quickly inventory is sold, not a direct measure of the company's ability to pay current liabilities with its most liquid assets.
Question 7
Hint
Focus on what the lender is worried about: near-term obligations and the quality of current assets available to pay them.
Answer B. The quick ratio (acid-test) is the most appropriate because it excludes inventory and other less liquid current assets, focusing on cash, marketable securities, and receivables. When inventory makes up a large portion of current assets and some inventory is slow-moving, the quick ratio gives a more conservative view of near-term ability to meet current liabilities than the current ratio. Since the lender is concerned with immediate payment capacity, the quick ratio is the most directly relevant follow-up.
Why not A: Tempting because the stem mentions slow-moving inventory, inventory turnover measures how quickly inventory is sold. However, it evaluates inventory efficiency, not the company's ability to pay current liabilities from its most liquid assets, so it doesn't directly answer the lender's liquidity concern.
Why not C: Tempting because lenders care about leverage and risk, but debt-to-equity assesses capital structure and long-term solvency rather than short-term liquidity. It does not indicate whether liquid assets are available to cover current obligations.
Why not D: Tempting because inventory problems can eventually affect margins, but gross profit percentage measures profitability on sales, not immediate liquidity. A company can have acceptable margins yet still struggle to pay current liabilities if too much of its current assets are tied up in inventory.
Question 8
Hint
Focus on the bank's stated concern and ask which ratio best measures near-term liquidity when inventory may not be readily saleable.
Answer C. The quick ratio (acid-test) excludes inventory and focuses on the most liquid assets relative to current liabilities. Because Harbor's inventory is slow-moving and may not be readily converted to cash, including inventory would overstate near-term liquidity. For a lender worried about the ability to meet obligations as they come due, the quick ratio is more informative than the broader current ratio or non-liquidity measures.
Why not A: Tempting because it measures current assets against current liabilities, but it includes inventory. When inventory may not be quickly converted to cash, the current ratio can overstate immediate liquidity compared with the quick ratio.
Why not B: This measures profitability (gross margin) rather than liquidity. It does not address the company's ability to pay current obligations in the near term, so it's not the best metric for the bank's stated concern.
Why not D: Debt-to-equity is a solvency or leverage measure about capital structure over the longer term. While lenders consider leverage, the bank's immediate concern is short-term liquidity, which the debt-to-equity ratio does not directly measure.
Common questions
How do you calculate the quick ratio?
Add unrestricted cash and cash equivalents, readily marketable short-term securities, and net trade receivables. Divide that total by all current liabilities, including the current portion of long-term debt.
Is restricted cash included in the quick ratio?
Cash restricted for long-term purposes is excluded because it is unavailable to pay current obligations. Include only unrestricted cash and cash equivalents.
What is the difference between the quick ratio and current ratio?
The current ratio includes all current assets. The quick ratio excludes inventory and prepaids, making it more useful when a lender wants to assess liquidity without relying on inventory sales.
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