Knowledge Check 01 Holding all else constant, a decrease in cash will decrease the acid-test ratio. True or False True False

Based on the way the acid-test ratio is calculated, when there is a decrease in cash, it is TRUE that the acid-test ratio will decrease.

The acid-test ratio is calculated as:

= (Current Assets - Inventory) / Current liabilities

Cash is a current liability which means that if it decreases, the numerator will decrease whilst the denominator will remain the same.

This will lead to the result being less. For instance, assume the (Current Assets - Inventory) reduced from $10 to $6 and the Current liabilities were $4, the acid test ratio would be:

Acid-test ratio before reduction:                       Acid - test ratio after reduction:

= 10 / 4                                                                   = 6 / 4

= 2.5                                                                      = 1.5

In conclusion, a reduction in cash reduces acid-test ratio.

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True

Explanation:

The acid-test ratio also referred to as the quick ratio is used to compare the short-term assets for a particular company to the short-term liabilities so as to know if the short-term debt can be settled quickly based on the available cash.

Holding all else constant, it should be noted that a reduction in cash will also lead to a reduction in acid-test ratio. We should note that when cash or any other short term investment reduces, there'll also be a reduction in the acid test ratio.

Therefore, the answer is True.