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14. Financial Statement Analysis

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Ratios: Quick (Acid Test) Ratio

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now let's discuss another ratio called the quick ratio. This is similar to the current ratio but it's a little more strict. Let's check it out. So the quick ratio is sometimes called the acid test ratio. And this isn't the 1970s. This isn't turn on tune in. Drop out. No, we're studying accounting here. It can't get any more bland. So let's check it out. We've got the quick ratio. It's going to be similar to the current ratio which you've probably studied. And remember the current ratio, we're talking about current assets, current liabilities being able to cover those liabilities in the short run. Well, the quick ratio is similar. It is another liquidity ratio liquidity ratio. Um but it's only going to use the most liquid assets in the numerator rather than all of our current assets. We're only gonna talk about the most liquid ones. Okay, so let's check out the quick ratio here And notice in our numerator, we no longer have current assets like we did when we studied the current ratio. Instead we have a small portion of our current assets. We've got cash which is very liquid short term investments. Those are also very liquid. That could be just shares of stock that you own. Anything that has some marketable value. Just like if you own a share of apple stock, right, you could look up the stock price and you could sell that stock right away at a stock price. So that's very liquid. And net accounts receivable. Those are generally pretty liquid as well. We're gonna be getting the money from our customers pretty soon. And even in in case we needed the money quicker, we can generally sell our accounts receivable to other companies and get a portion of them now. So they're very liquid as well. Okay. So one way that we can calculate the quick ratio is in our numerator to have those the cash, short term investments and the net accounts receivable, right? We could have those in our numerator and then our denominator is the same as the current ratio. It's just all of our current liabilities. Right? So we're still wanna check can we cover our current liabilities? But we want to see if we can cover them with these quick assets, these very very liquid assets. Okay, So another way we can think about the quick ratio is to do it the other way where we take all of our current assets notice in this case we start with all the current assets and this is to calculate the same thing, but except now we're taking all our current assets and we're gonna take stuff out that's not super liquid. So our inventory, we take out of our current assets and our prepaid expenses which are just not as liquid as our as the ones we described above. Right? So it's in the in essence we get to the same thing because those are the five most common current assets cash, short term investments, accounts receivable inventory and prepaid expenses. So we're taking out the less liquid ones and leaving only those very, very quick ones. Okay, so how do we analyze this ratio? Well, it's very similar to how we analyze a current ratio. The quick ratio? Well, it tells us how many highly liquid assets, so how many dollars of these highly liquid assets we have for each dollar of current liabilities. Right, So again, this has a similar red flag again to the current ratio very very similar in analysis. The quick ratio, if we have it below one, right? If we have a quick ratio below one, it can be signs of liquidity problems again, right, Because we're talking about being able to cover our current liabilities in the short term. And if we're not able to do that, well, we've got liquidity problems. But remember this is a little more strict, right? We're not talking about all of our current assets. We've been a little more strict than the current ratio. So a low current ratio is even more of a red flag than a low quick ratio because when we have inventory prepaid expenses in there, well, that can help us cover our current liabilities in one way or another. Alright, so let's go ahead and do an example. Let's use our quick ratio uh to to solve this problem right here. So we've got right here. Super liquid company has current assets totaling 450,000 and current liabilities totaling 315,000 Included in current assets are 115,000 of inventory. 35,000 of accounts receivable and 10,000 of prepaid expenses. Current liabilities include 120,000 in short term debt, calculate the quick ratio for slc. So this is something they love to do in accounting problems and especially in ratio problems to try and screw you up a little bit is to give you extraneous information. Remember our denominator in our in our quick ratio is all of our current liabilities right? That denominator is all of our current liabilities. So when we think about this example, they tell us that it includes 100 and 20,000 in short term debt. Well it doesn't matter. We want our total current liabilities down there. What about in our in our numerator, when we're talking about the current assets, part of those quick assets? Well, we have to calculate it. One of two ways we have to know our cash amount short term investments and our accounts receivable would be 1-1 way to calculate it, but they didn't tell us anything about cash, right? They didn't tell us the cash, they didn't mention invest. They might a lot of problems. Might not mention investments but here they didn't mention them at all. So the only one from that ratio would be accounts receivable. But when we think of it the other way there was a second way to calculate it. We can start with all of our current assets and subtract out the things that are not quick. Okay, so let's do it that way. It looks like we have the information for that. So let's go ahead and do our quick ratio. We're gonna start with our total current assets in the numerator which was 450,000 they told us right, 450,000 in total current assets. And then we're gonna subtract and subtract out the things that were not part of the quick ratio. So we had inventory right? They told us inventory is not quick. Right? It's not part of those quick assets. So we're gonna subtract 115,000 from those current assets and then accounts receivable. Well those were part of it. Right. Those were part of our quick assets in the first formula. So we're gonna leave those in but we want to subtract out these prepaid expenses, right? Those prepaid expenses. We subtract from our quick assets at a value of 10,000 And that's it for our numerator. Everything that's left over is going to be those quick assets, it's going to be the value of the cash and investments and accounts receivable there. Alright, so now let's move on to the denominator and this one's pretty easy. Right? All they did was trying to trick you with that short term debt but that was irrelevant. We want our total current liabilities all 315,000 in the denominator. So let's go ahead and put those in 315,000. And let's calculate this. So we've got 450,000. I'm gonna do it without the three zeroes for 50 minus 1. 15 minus 10. Gives us 325,000 in the numerator divided by the 315,000. So we're gonna have 325,000 divided by 315,000. And that gives us a quick ratio of 1.03. Right? So notice we're above one. Not much. Not by much but we are above one. So we're in a safe position to cover our our upcoming liabilities and current liabilities. Of course when we think about our current ratio. Well that would have a little more leg room there for covering those liabilities as well. Cool. Let's go ahead and pause here and then you guys try the next one in the practice problem.

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Problem

The following table contains selected financial information for Tougher Question, Inc.

Calculate the quick ratio for TQ, Inc.

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