Why is the acid-test ratio considered more stringent than the current ratio?

The acid-test ratio is considered more stringent than the current ratio because it excludes inventory from current assets.

The acid-test ratio, also known as the quick ratio, is a measure of a company's short-term liquidity and its ability to meet its immediate obligations without selling inventory. It is calculated by subtracting inventory from current assets and then dividing by current liabilities. This ratio is considered more stringent or conservative than the current ratio because it excludes inventory, which may not be easily converted into cash.

On the other hand, the current ratio includes all current assets, including inventory, in its calculation. It is calculated by dividing total current assets by total current liabilities. While this ratio provides a broader view of a company's short-term financial health, it may overstate liquidity if a significant portion of current assets is tied up in inventory that cannot be quickly sold.

Inventory is often excluded in the acid-test ratio because it is not always readily convertible into cash. The speed and ease with which inventory can be sold depend on various factors, including the nature of the inventory, market conditions, and the company's sales policies. For example, a company that sells perishable goods may struggle to quickly convert its inventory into cash without incurring losses. Similarly, a company in a slow-moving industry may have difficulty selling its inventory quickly.

Therefore, by excluding inventory, the acid-test ratio provides a more conservative view of a company's liquidity. It focuses on the most liquid assets - cash, marketable securities, and accounts receivable - that can be quickly converted into cash to meet immediate obligations. This makes it a more stringent measure than the current ratio, which may present a rosier picture of a company's short-term financial health by including inventory in its calculation.

In conclusion, while both the acid-test ratio and the current ratio are useful tools for assessing a company's short-term liquidity, the acid-test ratio is considered more stringent because it excludes inventory from its calculation. This provides a more conservative view of a company's ability to meet its immediate obligations without needing to sell inventory.