Year 12 IB Extended Essays 2017

Analysis of Current and Acid Ratio’s

The current ratio is a ratio that determines a company’s capability to pay short term and long

term requirements. In order to do this, the current ratio establishes a company’s total current

assets comparative to its total current liabilities. The formula Current Ratio = Current Assets /

Current Liabilities is then used to derive the ratio. From this, the current ratio simply measures

a company’s financial health where the higher the current ratio “the more capable the company

is of paying its obligations, as it has a larger proportion of asset value relative to the value of

its liabilities” (Investopedia, 2016). A ratio that shows assets under 1 signifies that the

company’s liabilities are greater than the assets, thus leading to the fact that a company is not

able to pay off their requirements if they were due.

The Acid ratio is a ratio that determines a company’s capability to pay short term requirements

with its most liquid assets, thus inventory is removed from this equation. From this it can be

understood that if an acid ratio test shows results much lower to the current ratio, “ it means

that current assets are highly dependent on inventory” (Investopedia, 2016). This is not in all

cases a bad scenario as retail companies such as Walmart and Target show acid ratios of 0.20

and 0.40 respectively. This is because of retail businesses high reliance on inventories as a

means of sales.

In June of 2013, post expansion, Dick Smith shows a stable financial condition as their current

ratio is 1.39:1. This demonstrates that they are in good financial health and can pay off

liabilities through the liquidation of all current assets. However, the acid ratio during this time-

period was 0.40 which shows that Dick Smith was not capable of paying immediate costs

through the liquidation of their assets when excluding inventory. Nevertheless, this still shows

positive health when compared to the likes of Walmart with the acid ratio at 0.20.

However, in June of 2015, during the company’s expansion, the current and acid ratios

plummeted by an average of 0.13. This shows Dick Smith’s decreasing financial stability due

to the massively increased amount invested in inventory as well as the $70m increase in

borrowings in order to fund the store expansion itself. Hence, proving the relation of Dick

Smith’s poor inventory management and store expansion to the collapse of the business itself.

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