Current Ratio

Analyst Ottilie Brandvold is reviewing Halstead Machine Works. The balance sheet shows current assets of $48 million, of which $20 million is inventory, and current liabilities of $24 million. The company current ratio and quick (acid-test) ratio are, respectively:

1. A.2.0 and 0.83Incorrect. 0.83 would come from dividing $20 million of inventory by $24 million of current liabilities, which is not the quick ratio.
2. B.2.0 and 2.86Incorrect. 2.86 comes from dividing $48 million by the $20 million of inventory, which measures nothing meaningful here.
3. C.2.0 and 1.17Correct. 48 / 24 = 2.0, and (48 - 20) / 24 = 1.17.
4. D.1.17 and 2.0Incorrect. The two figures are reversed. The current ratio is always the larger of the two when inventory is present.

Why: The current ratio divides all current assets by current liabilities: $48 million / $24 million = 2.0. The quick ratio strips out inventory, the least liquid current asset, before dividing: ($48 million - $20 million) / $24 million = $28 million / $24 million = 1.17. Both are liquidity measures, and the gap between them shows how much of the company short-term cushion depends on selling inventory.

Why does the quick ratio exclude inventory from current assets when the current ratio does not?

1. A.Because inventory is actually a liability, not an assetWrong. Inventory is an asset under both ratios; it is simply excluded from the quick ratio's numerator.
2. B.Because inventory is a noncurrent assetWrong. Inventory is a current asset; it is excluded for liquidity reasons, not classification reasons.
3. C.Because inventory is typically the least liquid current asset and its realizable value is uncertainCorrect. The quick ratio isolates the most readily convertible current assets, and inventory does not qualify.
4. D.Because the quick ratio excludes all current assets except cashWrong. The quick ratio still includes items like receivables and marketable securities, not cash alone.

Why: Inventory is typically the least liquid current asset — it must be sold and collected on before it becomes cash, and its realizable value is uncertain. The quick ratio is designed to test near-immediate liquidity, so it excludes inventory.

Meridian Tools' $150 million of current assets includes $50 million of inventory. Current liabilities are $100 million. What is the quick ratio (acid-test ratio)?

1. A.1.5xWrong. This is the current ratio; it fails to exclude inventory as the quick ratio requires.
2. B.2.0xWrong. This would result from dividing by an incorrect liability figure.
3. C.1.0xCorrect. ($150M − $50M) ÷ $100M = 1.0x.
4. D.0.5xWrong. This would result from dividing inventory alone by current liabilities.

Why: Quick ratio = (current assets − inventory) ÷ current liabilities = ($150M − $50M) ÷ $100M = 1.0x.

Fictional issuer Meridian Tools has current assets of $150 million and current liabilities of $100 million. What is its current ratio?

1. A.0.67xWrong. This inverts the ratio (liabilities ÷ assets instead of assets ÷ liabilities).
2. B.1.5xCorrect. $150M ÷ $100M = 1.5x.
3. C.$50 millionWrong. This subtracts instead of dividing, and a ratio is not expressed in dollars.
4. D.1.0xWrong. That would only be true if current assets equaled current liabilities.

Why: Current ratio = current assets ÷ current liabilities = $150M ÷ $100M = 1.5x.