The Acid test ratio also termed as the quick ratio is an effective indicator of how well a firm can handle its financial liabilities using the available short term assets. This metric measures the liquidity of the company by comparing the current assets in comparison to the current liabilities of the company.
Formula for calculating acid test ratio:
Acid test ratio = (cash + marketable securities +Accounts receivable)/current liabilities
Another formula commonly used for expressing acid test ratio/quick ratio:
Acid test ratio = (current assets – inventory)/current liabilities
The acid test ratio is a more conservative version of the current ratio(measures company’s ability to pay short and long term obligations)but it provides the rigorous assessment about the company’s potential to pay its current liabilities. This concept of analyzing the acid test ratio helps the company to get through the financial statements such as income statement, balance sheet etc.
Example to demonstrate acid test ratio:
Let us consider a set of records regenerated from the balance sheet of ABC company:
|Marketable securities||$20000||Portion of long-term debt||$20000|
|Accountable receivable||$40000||Payable notes||$10000|
|Current assets||$170000||Current liabilities||$90000|
Using the formula the acid test ratio of ABC company is:
($50000 + $20000 +$40000)/$90000 = 1.22
The ratio which is 1.22 in the above case signifies that the company ABC has $1.22 of liquid assets to cover the immediate or short-term obligations.
Note: Inventory is not included when calculating the acid test ratio.
How to analyze acid test ratio:
When the value of acid test ratio is below 1 it means that the company is not having sufficient liquid assets to pay the current liabilities. This means that the company might face some difficulty in paying off their short term debts and might need to sell off their assets to clear short-term obligations. Also when the value of acid test ratio is very less as compared current ratio it implies that the current assets are inventory dependent. If the calculated value of the acid test ratio is greater than 1 it means the company is sufficiently secure and capable of the paying the short-term debts with ease. Another point which is important to note here is that the ratio should not be very high as this would demonstrate that the company has a lot of ideal cash which is not reinvested.
The significance of calculating acid test ratio:
The biggest benefit of calculating the acid test ratio is that the company can feasibly understand the end results. Increasing acid test ratio of a company suggests that it is experiencing firm top line growth and is conveniently able to cover the financial obligations. Such companies encounter fast inventory turnover and cash conversion cycles. Declining acid test ratios suggest that the company is overleveraged struggling to stabilize or expand sales or gathering the receivables too slowly
Like other financial metrics, acid test ratio has its potential drawbacks. Analysts often argue that acid test ratio can’t provide any insight about the level and timings of cash flow. Also, its’ dependence on accounts receivable and current liabilities often create a problem. In any case, if the settlement between the creditors or debtors gets disputed the entire process of analyzing the acid test ratio becomes unbalanced. Minor calculations errors during the calculation can also prove to be misleading to the companies.