Association for Financial Professionals (AFP) Practice Exam

In terms of liquidity, which type of asset is excluded when calculating the current ratio?

1. Accounts receivable

2. Long-term investments

3. Prepaid expenses

4. Short-term investments

The correct answer is: Prepaid expenses

The current ratio is a measure of a company's liquidity, calculated by dividing current assets by current liabilities. To understand why prepaid expenses are excluded from this calculation, it is important to recognize what constitutes a current asset. Current assets are those expected to be converted into cash or used up within a year, thus providing liquidity. Prepaid expenses represent payments that have been made for goods or services to be received in the future. They are considered current assets on the balance sheet but do not provide liquid cash or cash equivalents in the short term. Since prepaid expenses have not yet generated economic benefits or cash inflows, they do not contribute incrementally to liquidity like accounts receivable or short-term investments that can readily be converted into cash. In contrast, accounts receivable represents outstanding invoices owed by customers, which are expected to be collected soon. Long-term investments, while they are not typically liquid, are not included in current assets. Short-term investments, which are investments in securities expected to be converted into cash within one year, do contribute to current assets and thus to liquidity. Therefore, prepaid expenses do not factor into calculating the current ratio since they do not directly enhance a company's immediate liquidity position.