Ratios help measure the relationship between two or more variables in quantitative terms. There are various kinds of profitability ratios, solvency ratios, turnover ratios, liquidity ratios, etc. However, one liquidity ratio that compares most liquid assets and short-term liabilities is the acid-test ratio.
What is the Acid-Test Ratio?
Also called the quick ratio, it is a liquidity ratio that measures a company’s ability to pay off current liabilities using its most liquid assets. The most-liquid assets include cash on hand, cash equivalents such as bank balance, marketable securities which can be sold or redeemed at any time, and account receivables. Current liabilities are those liabilities that are to be fulfilled within a year.
How to Calculate Acid Test Ratio?
It can be calculated by dividing its most liquid assets by current liabilities. Following is the formula to calculate the same.
Acid-test ratio = (Cash + Cash equivalents + Marketable securities + Current accounts receivables) / Total current liabilities
Acid-test ratio = (Current assets – Inventory – Prepaid expenses) / Total current liabilities
Following is an example for the same. For instance, ABC Limited has the following current assets and current liabilities.
|Current Assets||Amount||Current Liabilities||Amount|
|Accounts receivables||8,000||Short-term loans||25,000|
Acid-test ratio = (Cash + Accounts receivables + Marketable securities) / Total current liabilities
= (50,000 + 8,000 + 10,000) / (12,000 + 25,000 +15,000)
How To Interpret?
The ideal ratio differs among industries. Additionally, the life cycle stage, nature of the business, debtors and creditors cycle, etc., are among the few factors that affect the company’s acid-test ratio. However, here are some common interpretations of its levels.
The acid-test ratio of 1 suggests that the company has the equivalent amount of liquid assets as current liabilities. It means the company can pay off its current liabilities by selling all of its liquid assets.
Higher than one suggests that the company has enough liquid assets to meet its short-term financial obligations. However, it is also important to note that a significantly high test ratio may signify the company has idle cash, which can be utilized to earn returns.
However, when lower than one, it indicates that the company can fall short on liquid assets to meet its short-term financial obligations.
When To Use the Acid-Test Ratio?
It is used when the current assets that can be quickly converted to cash are a concern and excludes inventory that takes time to convert into cash. Therefore, it gives a more conservative idea of the company’s liquidity.
Investors may use the it to make investment decisions based on the company’s ability to meet financial obligations. It becomes a critical indicator whenever the cash flow is concerned.
Creditors and suppliers may use this ratio to assess whether the company has enough liquid assets to pay its dues.
Limitations of Acid-Test Ratio
- It assumes that the company meets its short-term financial obligation with current assets, which is only sometimes true. Often the company uses operating cash flow to pay off debts.
- It presumes that the accounts receivables can be easily converted to cash within the predetermined period, which may or may not happen. If the accounts receivables take more time or convert to bad debt, the result of the ratio can be misleading.
- The ratio ignores long-term liabilities; some of them may be due in a year or less from the time it is calculated. The ratio only considers quantitative factors and avoids qualitative factors such as the company’s relationship with the supplier or creditor, which may enable them to manage their obligations effectively.
- In isolation may not help in accurately estimating the company’s liquidity position. It should be considered along with other ratios, such as the current ratio, cash ratio, etc., to analyze the liquidity position.
Difference Between Current and Acid-Test Ratio
The primary difference between the current and acid-test ratios is that the later is stricter regarding the company’s liquidity condition and considers only cash or current assets that can be easily and quickly converted to cash. On the other hand, the current ratio considers all the current assets, including inventory and prepaid expenses.
For instance, suppose the company has the following current assets and liabilities.
|Current Assets||Amount||Current Liabilities||Amount|
|Accounts receivables||5,000||Short-term loans||20,000|
Here, Current ratio = Current assets/Current liabilities = (35,000 + 5,000 + 10,000) / (10,000 + 20,000) = 1.67:1
Acid-test ratio = (35,000 + 5,000) / (10,000 + 20,000) = 1.33:1
Thus, the result would be different.
Frequently Asked Questions
This ratio is an important financial measure indicating the company’s ability to fulfill short-term liabilities such as accounts payable, short-term loans, etc., using most liquid assets such as cash, cash equivalents, marketable securities, etc.
A higher ratio signifies that the company has enough liquid assets to meet its short-term financial obligations.
A lower acid test ratio indicates that the company has lesser liquid assets to meet its short-term financial obligations.
The quick ratio, also called the acid test ratio, is the measure of a company’s most liquid assets’ ability to pay off short-term liabilities.