Inventory is excluded when the quick ratio or acid-test ratio is calculated becauseinventory is the most difficult current asset to convert to cash without loss of value. Whattypes of inventory are likely to be most easily converted to cash?For the quick ratio, one uses only the most liquid of all assets—that is, all current assetsless inventory, which is not very liquid relative to cash or receivables. While the currentratio assumes that inventory could be sold at book value, the quick ratio assumes thatinventory has no value. Hence, this gives a more conservative estimate of a firm’sliquidity than the current ratio, and gives a better estimate of the firm’s ability to meet itsshort-term obligations.
What does a very high inventory turnover ratio signify? This could mean a number of things, including that the firm is using up its inventory toofast and is unable to meet the demand for its products, or it has priced its products toolow relative to its competitors, or worse, the firm is selling defective products that wouldeventually be returned.
How would one explain a low receivables turnover ratio?A low receivables turnover implies a high DSO. This could mean that the firm’scustomers are not paying on time, either because of an inefficient collection system orbecause of a slowdown in their customers’ business or even in the entire economy.