An underwriter finds a current ratio of 1.2. Which adjustment should be made to reflect short-term obligations?

An underwriter finds a current ratio of 1.2. Which adjustment should be made to reflect short-term obligations?

• A. Subtract the company's inventory from current assets in the ratio calculation
• B. Add the company's inventory to current assets
• C. Exclude inventory from current assets entirely
• D. Use total assets instead

Answer: (A)

Liquidity analysis often uses the quick ratio to gauge immediate ability to meet short-term obligations. The current ratio includes all current assets, but inventory isn’t as liquid as cash or receivables, so a more conservative measure excludes it. Subtracting inventory from current assets and then dividing by current liabilities gives the quick ratio, which focuses on assets that can be quickly converted to cash to cover obligations. With a current ratio of 1.2, removing inventory would typically lower the ratio, signaling less liquid cushion and a better reflection of short-term risk. Adding inventory would inflate the measure, using total assets ignores current liabilities, and excluding inventory entirely is essentially the same idea but the standard approach is to compute (current assets minus inventory) over current liabilities.

Liquidity analysis often uses the quick ratio to gauge immediate ability to meet short-term obligations. The current ratio includes all current assets, but inventory isn’t as liquid as cash or receivables, so a more conservative measure excludes it. Subtracting inventory from current assets and then dividing by current liabilities gives the quick ratio, which focuses on assets that can be quickly converted to cash to cover obligations. With a current ratio of 1.2, removing inventory would typically lower the ratio, signaling less liquid cushion and a better reflection of short-term risk. Adding inventory would inflate the measure, using total assets ignores current liabilities, and excluding inventory entirely is essentially the same idea but the standard approach is to compute (current assets minus inventory) over current liabilities.