Acid-test ratio

Table of Contents

Acid-test ratio
What is the acid-test ratio?
Understanding the acid-test ratio
Formula
Calculating the ratio
Example
Frequently Asked Questions

Acid-test ratio

The acid-test ratio, or the quick ratio, is a financial term used to assess a company’s short-term liquidity and ability to meet its immediate economic issues. Investors and creditors often use this ratio to determine a firm’s capacity to pay off its current liabilities without depending on the sale of stock. By excluding stock from the calculation, the acid-test ratio offers a more conservative measure of a company’s liquidity position. Here, we will delve into the concept of the acid-test ratio, its formula, calculation, application, and limitations.

What is the acid-test ratio?

The acid-test ratio is a financial ratio used to measure an industry’s ability to settle its current liabilities with its most liquid assets, excluding stock. It is a more rigid measure of liquidity than the current ratio since the list can sometimes be difficult to sell quickly, especially in financial distress. The acid-test ratio provides insight into how well a company can cover its short-term obligations with readily available assets.

Understanding the acid-test ratio

The acid-test ratio is crucial for determining a company’s short-term liquidity condition, particularly in recessionary or financially challenging times. As it doesn’t include stock, it is a more cautious measure of liquidity than the current ratio. This exclusion is especially useful in sectors where the stock’s market value is subject to wide fluctuations or if stock turnover is delayed.

The acid-test ratio offers a perception of a company’s capacity to manage unforeseen cash needs or emergencies by concentrating on the most liquid assets. Since a higher percentage of their assets may be quickly turned into cash without suffering large losses, businesses with a high acid-test ratio are often better positioned to withstand financial crises.

For example, consider a retail company with substantial stock and slow stock turnover. The company might face difficulties selling its stock quickly during an economic downturn or decreased consumer spending. In such a situation, the acid-test ratio would reveal the company’s liquidity position by excluding the potentially illiquid stock.

Another aspect that adds to the value of the acid-test ratio is its ability to highlight potential collection issues. While accounts receivable are included in the balance, it does not account for the timing of collections. Companies might show a strong acid-test ratio, indicating sufficient receivables, but if the collections are delayed or unreliable, it could lead to liquidity problems.

Formula

The formula for calculating the acid-test ratio is as follows:

Acid-test ratio = (current assets – inventory) / current liabilities

Where:

Current assets = Total amount of a company’s assets that are anticipated to be turned into cash within a year. Cash, accounts receivable, cash equivalents, and other short-term investments fall under this category.

Inventory = Market worth of the goods the firm has on hand for resale.

Current liabilities = Company’s entire short-term debts and liabilities due within a year. Short-term loans, accounts payable, and other current obligations fall under this category.

Calculating the ratio

To determine the acid-test ratio, perform the following steps:

Step 1: Analyse the balance sheet of the firm to assess the worth of cash, cash equivalents, marketable securities, and accounts receivable.
Step 2: Add together all the data from Step 1 to determine the total amount of liquid assets.
Step 3: Analyse the balance sheet of the firm to estimate the current liabilities’ worth.
Step 4: Subtract the current obligations (from Step 3) from the total liquid assets (from Step 2).

Example

Let’s consider an example to illustrate the calculation of the acid-test ratio: Company XYZ has the following financial information:

Cash: US$10,000

Cash Equivalents: US$5,000

Marketable Securities: US$3,000

Accounts Receivable: US$7,000

Current Liabilities: US$10,000

Acid-test ratio = (US$10,000 + US$5,000 + US$3,000 + US$7,000) / US$10,000

Acid-test ratio = US$25,000 / US$10,000

Acid-test ratio = 2.5

In this example, company XYZ has an acid-test ratio of 2.5, indicating that for every US$1 of current liabilities, it has US$2.5 of easily accessible assets to cover those obligations.

Frequently Asked Questions

What does an acid test ratio of 1.5:1 mean?

An acid-test ratio of 1.5:1 means a company has US$1.5 of liquid assets (excluding stock) to cover every US$1 of current liabilities. This suggests the company is well-equipped to meet its short-term obligations using readily available support.

What is the acid test ratio and the current ratio?

The acid test and current ratios are both measures of a company’s liquidity, but they differ in the assets considered. The acid test ratio only finds the most liquid assets (cash, cash equivalents, marketable securities, and accounts receivable) and excludes stock. On the other hand, the current ratio includes all current assets, including inventory. As a result, the acid-test ratio is a more conservative measure of liquidity.

What is the application of the acid test ratio?

Investors, creditors, and analysts commonly use the acid-test ratio to evaluate a company’s short-term liquidity position. It helps assess whether a company can meet its immediate financial obligations without relying on stock sales. A high acid test ratio is generally considered favourable, indicating a strong ability to cover short-term liabilities.

What are the limitations of the acid test ratio?

The acid-test ratio has some limitations. Since it excludes stock, it may not provide a complete picture of a company’s liquidity. The stock might be highly liquid in certain industries and easily convertible to cash. Additionally, the acid-test ratio does not consider the timing of accounts receivable collections, which can impact a company’s ability to meet its short-term obligations.

What is quick ratio?

A financial indicator known as the quick ratio, or the acid-test ratio, is used to evaluate a company’s short-term liquidity and capacity to satisfy its immediate financial commitments. It gauges a business’s capacity to pay its obligations with its most liquid assets, excluding inventories. (Cash + cash equivalents + marketable securities + accounts receivable) / current liabilities is the formula for determining the quick ratio. Investors and creditors frequently use the quick ratio as a more cautious measure of liquidity than the current ratio to assess a company’s short-term financial stability.