Chapter 3: Decision Analysis: Acid-Test and Gross Margin Ratios

Acid-Test Ratio and Gross Margin Ratio Both the acid-test ratio and gross margin ratio are important financial metrics used to assess a company's liquidity and profitability. Below is an explanation of how each ratio is computed and what it indicates about a company’s financial health. 1. Acid-Test Ratio (Quick Ratio) The acid-test ratio is a measure of a company's ability to pay off its current liabilities without relying on the sale of inventory. It focuses on "quick assets," which include cash, short-term investments, and accounts receivable—items that can quickly be converted to cash. The formula is: Acid-Test Ratio=Quick AssetsCurrent Liabilities Quick assets exclude inventory and prepaid expenses, as these are less liquid. Formula: Acid-Test Ratio=Cash+ShortTerm Investments+Current ReceivablesCurrent Liabilities Example Calculation: If KC Antiques has the following balances: • • • Cash: $7,000 Accounts Receivable: $13,000 Current Liabilities (Accounts Payable + Salaries Payable): $11,000 Acid-Test Ratio=7,000+13,00011,000=20,00011,000=1.82 Interpretation: • • A 1.82 acid-test ratio means KC Antiques has $1.82 in quick assets for every $1.00 of current liabilities. This indicates that the company has strong liquidity and can easily cover its short-term obligations without depending on inventory sales. Typically, an acid-test ratio near or above 1.0 is considered healthy. A ratio below 1.0 might raise liquidity concerns, as it indicates the company may struggle to pay its liabilities without liquidating inventory. 2. Gross Margin Ratio The gross margin ratio measures how much of every sales dollar remains after deducting the cost of goods sold (COGS), which represents the basic cost of merchandise sold by the company. This ratio shows how efficiently a company is managing its production or purchasing processes. Gross Margin Ratio=Gross ProfitNet Sales Where: • Gross Profit = Net Sales − COGS Formula: Gross Margin Ratio=Net Sales−COGSNet Sales Example Calculation: If KC Antiques has the following values: • • • Net Sales: $332,250 Cost of Goods Sold (COGS): $159,900 Gross Profit = $332,250 − $159,900 = $172,350 Interpretation: • • A 52% gross margin ratio means that for every $1.00 in sales, KC Antiques retains 52¢ to cover operating expenses and generate profit. The remaining 48¢ represents the cost of acquiring the merchandise. This ratio is critical because it shows whether the company can cover other expenses, like selling and administrative costs, and still make a profit. A higher gross margin ratio is usually favorable, indicating better control over production costs or pricing strategies. Comparison and Analysis: • • Acid-Test Ratio: KC Antiques’ ratio of 1.82 is solid, showing a strong ability to cover its immediate liabilities. If this were lower (e.g., below 1.0), it would signal potential liquidity issues, where the company might have to rely on inventory sales to pay off its debts. This high ratio reduces the risk of insolvency in the short term. Gross Margin Ratio: KC Antiques’ gross margin of 52% indicates that the company retains a good portion of its sales revenue after covering the cost of goods sold. This is a healthy margin, meaning the company is efficiently managing its cost of goods, which leaves room for covering operating expenses and generating profit. Conclusion: • • The acid-test ratio of 1.82 indicates that KC Antiques is in a strong liquidity position, able to cover its short-term liabilities with its most liquid assets. The gross margin ratio of 52% suggests that the company is maintaining a healthy margin between sales and COGS, which is a good indicator of its profitability. However, the company should continue monitoring its COGS and sales pricing strategies to maintain or improve this ratio over time.