A construction company's current ratio is 1.8, and its quick ratio is 1.2. This indicates that:
Correct Answer
A) Inventory represents a significant portion of current assets
The difference between current ratio (1.8) and quick ratio (1.2) of 0.6 indicates that inventory and other less liquid current assets represent a significant portion of current assets, as the quick ratio excludes these items.
Why This Is the Correct Answer
The current ratio includes all current assets (cash, receivables, inventory, prepaid expenses) while the quick ratio excludes inventory and other less liquid assets. The difference of 0.6 (1.8 - 1.2) represents the portion of current assets tied up in inventory and other non-liquid current assets. This 0.6 difference divided by current liabilities shows that inventory comprises a substantial portion of the company's current assets, making option A correct.
Why the Other Options Are Wrong
Option B: Long-term debt is too high
These ratios measure short-term liquidity, not long-term debt levels. Both ratios only consider current assets and current liabilities. Long-term debt would be analyzed using debt-to-equity ratios or debt service coverage ratios, not current or quick ratios. The company's long-term debt position cannot be determined from these liquidity metrics alone.
Option C: The company has excessive cash reserves
A current ratio of 1.8 and quick ratio of 1.2 are healthy but not excessive. Excessive cash would result in very high quick ratios (significantly above 1.5-2.0) with minimal difference between current and quick ratios. The 0.6 difference actually indicates inventory, not excess cash, comprises the gap between these ratios.
Option D: The company cannot meet short-term obligations
Both ratios are above 1.0, indicating the company can meet short-term obligations. A current ratio of 1.8 means current assets are 1.8 times current liabilities, and a quick ratio of 1.2 means liquid assets are 1.2 times current liabilities. These are healthy liquidity positions, not indicators of inability to pay short-term debts.
Memory Technique
Remember 'Current minus Quick equals Inventory thick' - the difference between current ratio and quick ratio reveals how much inventory weighs down your liquid position.
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