What's the difference between the current ratio and the acid-test ratio?

The current ratio measures a company's ability to pay short-term obligations, while the acid-test ratio excludes inventory from current assets.

The current ratio and the acid-test ratio are both financial metrics used to evaluate a company's liquidity, or its ability to meet short-term obligations. However, they differ in the types of assets they consider.

The current ratio, also known as the working capital ratio, compares a company's current assets to its current liabilities. Current assets include cash, accounts receivable, inventory, and other assets that can be converted into cash within one year. Current liabilities, on the other hand, are obligations that must be paid within the same timeframe. A current ratio of 1 or more indicates that a company has enough assets to cover its short-term liabilities.

The acid-test ratio, also known as the quick ratio, is a more stringent measure of liquidity. It excludes inventory from current assets, as inventory may not be easily converted into cash, especially in the case of a sudden need. This ratio only considers the most liquid assets: cash, marketable securities, and accounts receivable. By comparing these assets to current liabilities, the acid-test ratio provides a clearer picture of a company's ability to meet its immediate obligations without relying on the sale of inventory.

Both ratios are useful tools for investors and creditors to assess a company's financial health. However, the acid-test ratio is considered a more conservative measure, as it only includes assets that can be quickly converted into cash. It's particularly useful for businesses with high inventory levels, as it can highlight potential liquidity issues that the current ratio might overlook.

In summary, while both the current ratio and the acid-test ratio provide valuable insights into a company's liquidity, they differ in the types of assets they consider. The current ratio includes all current assets, while the acid-test ratio only considers the most liquid ones.