Acid Test Ratio

The ratio of current assets less inventories to total current liabilities.

This ratio is the most stringent measure of how well the company is covering its short-term obligations, since the ratio only considers that part of current assets that can be turned into cash immediately (thus the exclusion of inventories). The ratio tells creditors how much of the company’s short-term debt can be met by selling all the company’s liquid assets at very short notice. also called the acid-test ratio.

The numerator of the acid-test ratio can be defined in a variety of ways, but the most important thing to remember is to get a realistic picture of the company’s liquid assets. Cash and cash equivalents, as well as short-term investments like marketable securities, should all be included.

Accounts receivable are commonly included, but this is not appropriate in all industries. Accounts receivable, for example, may take much longer to recover in the construction industry than in other industries, so including it could make a company’s financial position appear much more secure than it is in reality.

The formula is as follows:

Acid Test= (Cash + Marketable Securities + Accounts Receivable) /Current Liabilities

The numerator can also be calculated by taking all current assets and subtracting illiquid assets. Most importantly, inventory should be subtracted, keeping in mind that, due to the amount of inventory carried by retail businesses, this will negatively skew the picture. Other assets on a balance sheet, such as advances to suppliers, prepayments, and deferred tax assets, should be subtracted if they cannot be used to cover liabilities in the short term.

All current liabilities, which are debts and obligations due within one year, should be included in the ratio’s denominator. It’s worth noting that time isn’t taken into account when calculating the acid-test ratio. If a company’s accounts payable are approaching the due date but its receivables are months away, the company may be in much worse shape than its ratio suggests. It’s also possible that the opposite is true.

The current ratio, also known as the working capital ratio, and the acid-test ratio both assess a company’s ability to generate enough cash in the short term to pay off all of its debts if they all came due at the same time. The acid-test ratio, on the other hand, is considered more conservative than the current ratio because it excludes items like inventory, which can be difficult to liquidate quickly. Another significant distinction is that the acid-test ratio only considers assets that can be converted to cash in 90 days or less, whereas the current ratio considers assets that can be converted to cash in one year.

The acid test, also known as the quick ratio, determines whether a company has or can obtain sufficient cash to pay off its immediate liabilities, such as short-term debt. The acid-test ratio should be greater than one in most industries. If it’s less than one, the company doesn’t have enough liquid assets to cover its current liabilities, and it should be avoided. If the acid-test ratio is significantly lower than the current ratio, a company’s current assets are heavily reliant on inventory. A high ratio, on the other hand, may indicate that cash has accumulated and is not being reinvested, returned to shareholders, or otherwise put to productive use.

Divide a company’s current cash, marketable securities, and total accounts receivable by its current liabilities to get the acid-test ratio. The balance sheet of the company contains this information.

While the numerator variables can be changed, each variation should reflect the most accurate picture of the company’s liquid assets. Cash and cash equivalents, as well as short-term investments like marketable securities, should be included. Because this figure is not appropriate for every industry, accounts receivable is sometimes excluded from the calculation. All current liabilities, which are debts and obligations due within one year, should be included in the ratio’s denominator.