Acid Test Ratio

The Acid-Test Ratio, sometimes referred to as the Quick Ratio, is a liquidity ratio that assesses how well a company's current liabilities are covered by its short-term assets. To put it another way, the acid-test ratio is a gauge of a company's ability to meet its current (short-term) financial obligations.

The term "acid-test ratio" refers to the practice of historically testing metals for gold using acid. A metal was deemed genuine gold if acid was put on it, and it did not corrode. However, if the test was unsuccessful, the metal was thought to be worthless.

Acid Test Ratio/ Quick Ratio Calculations

To calculate the acid-test ratio of a company, divide a company's current cash, marketable securities, and total accounts receivable by its current liabilities.

This information can be found on the company's balance sheet.

  • Cash and cash equivalents, which include savings accounts, term deposits with maturities of under three months, and T-bills, are the most liquid current assets on a company's balance sheet.
  • Marketable securities are easily convertible into cash since they are liquid financial products.
  • The money owing to the business by customers for goods and/or services is known as accounts receivable.
  • Current liabilities are loans or other obligations with a one-year maturity.

Interpretation

An organization is deemed to be financially secure and capable of meeting its short-term obligations if its acid test ratio is greater than 1.0. The fact that this ratio does not include inventory, which is thought to take longer to convert into cash, makes it a more cautious measurement than the often-used current ratio.

As a rule, a low or declining trend in the acid test ratio typically signifies that a company may experience weak top-line growth and have trouble managing working capital as a result of a shorter creditor term or longer receivable period.

If the acid test ratio is low or on the decline, a company may have trouble managing working capital due to weak top-line growth, a shorter creditor period, or a longer receivable time.

Advantages

  • It removes inventory from the calculation.
  • Cash credit and bank overdraft are likewise eliminated from the list of current liabilities.
  • It is not handicapped as there is no need for valuation of inventory.
  • Provides more reliable information in the industry which is seasonal in nature.

Disadvantages

  • When employed as a stand-alone ratio, it is inappropriate.
  • It may not be suitable for businesses where inventory can be valued at a marketable price easily.
  • This ratio might not be a good indicator for all business models for showing short term solvency.
  • It ignores the level and the timing of the cash flows.

What's The Difference Between Current And Acid-Test Ratios?

The acid-test ratio and the current ratio, commonly referred to as the working capital ratio, both assess a company's ability to earn enough cash in the short term to settle all debts should they become due at once. The acid-test ratio, however, is seen as being more cautious than the current ratio because its computation disregards things like inventories, which could be challenging to swiftly unload. The acid-test ratio only covers assets that can be converted into cash in less than 90 days, whereas the current ratio also includes assets that can be converted into cash in less than a year.

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