Question

Identify similarities and differences between the acid-test ratio and the current ratio. Compare and describe how the two ratios reflect a company’s ability to meet its current obligations.

Short answer

Current ratio and acid-test ratio areboth used by analysts to assess the liquidity of a business entity. But both ratios differ from the perspective of time because current ratio measures the ability to pay within an operating period, while acid-test ratio measures the ability to meet an obligation immediately.

Step-by-step solution

Definition of Operating Cycle

The total time spent by a business entity from the initial activity of producing goods to the collection of cash from the customer is known as the operating cycle.

Similarities and differences between acid-test ratio and current ratio

Differences:

1. Current ratio establishes a relation between current assets and current liabilities, while acid-test ratio establishes a relation between liquid assets and current liabilities.
2. Current ratio defines the ability to meet an obligation within one year, but acid-test ratio defines the ability to meet an obligation immediately.

Similarities:

1. Acid-test ratio and current ratio are used to determine the liquidity of a business entity.
2. Both ratios use current liabilities and denominators.

Information reflected by each ratio

Current ratio and acid-test ratio both determine the ability of a business to meet short-term obligations. Still, current ratio reflects the ability to meet these expenses within one year, and acid-test ratio reflects the ability to meet these expenses immediately.