The acid test ratio, also known as the quick ratio, is a liquidity metric used to evaluate a company’s short-term liquidity position. It is a type of financial ratio used to determine a company’s liquidity by measuring the ability of a company to pay its current liabilities with its most liquid assets. It is a conservative measure of liquidity, as it excludes the inventory and other current assets that may not be easily converted into cash. It measures the proportion of current assets that can be used to pay off current liabilities without relying on the sale of inventory. The acid test ratio is an important measure of financial strength and provides a good indication of a company’s ability to pay its debts. A good acid test ratio is an indication of a company’s financial health. It is important for both investors and creditors to understand how the acid test ratio affects a company’s financial strength and liquidity. In this blog post, we will discuss the acid test ratio in detail, including how
Quick Ratio (Acid Test Ratio)
How to calculate the acid test ratio
The acid-test ratio can be calculated using the following formula:
Acid test ratio is equal to (cash plus short-term investments plus current receivables) / current liabilities.
1. Add cash + short term investments + current receivables
Cash also includes easily liquidated assets. Depending on the company’s industry, accounts receivables are sometimes combined with current receivables. Construction firms, for instance, might not include accounts receivables because they might be more difficult to collect than in other sectors. This is crucial to take into account because these numbers may give the impression that the company is financially more secure than it actually is.
The total current assets should be reduced by any assets that cannot be taken into account when calculating short-term liquidity. For instance, because it is unpredictable, inventory on hand shouldn’t be counted as a liquid asset or used in the calculation of the acid-test ratio.
Prepayments, deferred tax assets, and advances to suppliers are possible additional assets that should be excluded from this calculation because they can skew the company’s actual liquidity.
2. Divide the sum from step 1 by current liabilities
Included in this calculation should be all obligations due within a year or earlier. This formula shouldn’t include any additional liabilities because doing so would produce erroneous results. Your acid-test ratio will be determined by dividing the amount from step 1 by all of your current liabilities.
One final point: the ratio’s calculation does not take time into account. This is crucial because the acid-test ratio might deceivingly omit the financial difficulties the company may be experiencing in the short term if the company has payables that are due soon but its receivables won’t be recovered for several months.
The opposite can be true, as well. The company may appear to be financially stable if its receivables arrive all at once and its payables aren’t due for some time.
What is the acid test ratio?
A company can determine its immediate liquidity, or ability to pay its short-term obligations, by reviewing data from their current balance sheet and calculating the acid-test ratio.
The acid-test ratio, which only displays assets that can be converted into cash within one quarter and excludes all other assets, such as inventory, is frequently more accurate than working capital numbers.
Consult the information below from your company’s most recent balance sheet to determine your company’s acid-test ratio:
What do the results of the acid test ratio mean?
The acid-test ratio’s estimate of a company’s ability to pay its current liabilities without seeking out additional funding is a conservative one. This quick ratio measures the financial health of the company, with a higher number indicating greater liquidity and a lower number (less than one) indicating impending financial difficulties.
For instance, if a company’s acid-test ratio is 2, it means that its liquid assets are worth twice as much as its current liabilities. Therefore, if the current liabilities are $100,000 and the acid-test ratio is 2, the liquid assets would be $200,000 in this scenario. This ratio is indicative of good financial health.
It’s crucial to keep in mind that a ratio that is too high may indicate that a company isn’t making wise use of its resources. A disproportionate amount of accounts receivable may indicate that the business isn’t doing a good job of collecting what is owed to it, while too much extra cash may indicate that it isn’t being invested in expanding the business.
However, businesses with low acid-test ratios (less than 1) are thought to have insufficient access to liquid assets for the purpose of covering their current liabilities. The company could be facing financial troubles. Although a low acid-test ratio isn’t always a bad thing,
For instance, a chain of retail stores that depend on shifting inventory may have a low acid-test ratio. The acid-test ratio only considers the short-term health of the company because it is only an estimate.
Faqs about acid-test ratios
Here are answers to frequently asked questions about acid-test ratios:
Is there an ideal acid-test ratio result?
Although there is no single ratio range or number that is optimal for all industries, in general, the ratio should be greater than one. Depending on the sector, the size and the stability of the company’s finances, the ideal number will change.
An established company of a certain size may find that the acid-test ratio is not particularly important because it operates under long-term revenue terms or has excellent credit, which enables it to access short-term funding when necessary.
Are there any drawbacks to using the acid-test ratio?
The acid-test ratio has a lot of benefits, but there are some potential disadvantages as well, such as:
Acid test ratio example
Utilizing information from the company’s balance sheet for the desired period, the acid-test ratio is calculated. Here is an illustration of how to calculate the acid-test ratio on a balance sheet:
