Correct Option: B. 1:2 Explanation of the Acid Test Ratio The acid test ratio, also known as the quick ratio, is a financial metric used to assess a company's short-term liquidity position. It measures a company's ability to pay off its current liabilities without relying on the sale of inventory. The formula for the acid test ratio is: [ \text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} ] Step-by-Step Calculation

1. Identify Current Assets: These are assets that are expected to be converted into cash or used up within one year. This typically includes cash, accounts receivable, and inventory.
2. Subtract Inventories: Since the acid test ratio excludes inventory (which may not be easily liquidated), we subtract the value of inventory from current assets.
3. Identify Current Liabilities: These are obligations that the company needs to settle within one year, such as accounts payable, short-term loans, and other short-term debts.
4. Calculate the Ratio: After obtaining the adjusted current assets (current assets minus inventories), divide this figure by the current liabilities.

Example Calculation Let’s assume a company has the following financial data:

• Current Assets: $200,000
• Inventories: $50,000
• Current Liabilities: $100,000

Using the formula:

1. Calculate Adjusted Current Assets: [ \text{Adjusted Current Assets} = \text{Current Assets} - \text{Inventories} = 200,000 - 50,000 = 150,000 ]
2. Calculate Acid Test Ratio: [ \text{Acid Test Ratio} = \frac{150,000}{100,000} = 1.5 ]

This means the acid test ratio is 1.5:1, indicating that for every dollar of current liabilities, the company has $1.50 in liquid assets. Why Option B (1:2) is Correct In the context of the question, if the acid test ratio is stated as 1:2, it implies that for every $1 of current liabilities, the company has $2 in liquid assets. This is a strong liquidity position, indicating that the company can comfortably meet its short-term obligations. Why Other Options are Incorrect

• Option A (1:1): This indicates that the company has exactly enough liquid assets to cover its current liabilities. While this is acceptable, it does not provide a buffer for unexpected expenses or downturns, making it a weaker position than 1:2.
• Option C (2:3): This ratio suggests that for every $3 of current liabilities, the company has only $2 in liquid assets. This indicates a liquidity problem, as the company does not have enough liquid assets to cover its liabilities.
• Option D (3:2): This indicates a very strong liquidity position, suggesting that the company has $3 in liquid assets for every $2 of liabilities. While this is a good position, it is not the correct answer based on the question's context.

Common Pitfalls

• Confusing Current Ratio with Acid Test Ratio: The current ratio includes inventory in its calculation, while the acid test ratio does not. Always remember to exclude inventory when calculating the acid test ratio.
• Misinterpreting Ratios: A higher ratio is generally better, but it’s important to consider industry standards. Some industries may operate with lower liquidity ratios.

Revision Summary

• The acid test ratio measures a company's ability to meet short-term liabilities without relying on inventory.
• The formula is: (\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}}).
• A ratio of 1:2 indicates a strong liquidity position, while lower ratios suggest potential liquidity issues.
• Always exclude inventory from current assets when calculating the acid test ratio.