A liquidity ratio that measures a company's ability to use its short-term assets to cover current liabilities
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The Acid-Test Ratio, also known as the quick ratio, is a liquidity ratio that measures how sufficient a company’s short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations. This guide will break down how to calculate the ratio step by step, and discuss its implications.
The Acid-Test Ratio Formula
The formula for calculating the ratio is as follows:
The following items can all be found on a company’s balance sheet:
Cash and cash equivalents are the most liquid current assets on a company’s balance sheet, such as savings accounts, a term deposit with a maturity of fewer than 3 months, and T-bills.
Marketable securities are liquid financial instruments that can be readily converted into cash.
Accounts receivables are the money owed to the company from providing customers with goods and/or services.
Current liabilities are debts or obligations due within one year.
The acid-test ratio formula can alternatively be rendered as follows:
Current assets are assets that can be reasonably converted into cash within a year.
Inventories are the value of materials and goods held by a company with the intention of selling them to customers.
The logic here is that inventory can often be slow moving and thus cannot readily be converted into cash. Additionally, if it were required to be converted quickly into cash, it would most likely be sold at a steep discount to the carrying cost on the balance sheet.
Example of the Acid-Test Ratio
Consider three hypothetical companies:
Here are the calculations of the acid-test ratio for each company:
Note: To determine the current liabilities for each company, total liabilities are subtracted from non-current liabilities.
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Interpretation of the Acid-Test Ratio
The acid-test ratio is used to indicate a company’s ability to pay off its current liabilities without relying on the sale of inventory or on obtaining additional financing. Inventory is not included in calculating the ratio, as it is not ordinarily an asset that can be easily and quickly converted into cash. Compared to the current ratio – a liquidity or debt ratio which does include inventory value in the calculation – the acid-test ratio is considered a more conservative estimation of a company’s financial health.
The higher the ratio, the better the company’s liquidity and overall financial health. A ratio of 2 implies that the company owns $2 of liquid assets to cover each $1 of current liabilities. However, it’s important to note that an extremely high quick ratio (for example, a ratio of 10) is not considered favorable, as it may indicate that the company has excess cash that is not being wisely put to use growing its business. A very high ratio may also indicate that the company’s accounts receivables are excessively high – and that may indicate collection problems.
The optimal acid-test ratio number for a specific company depends on the industry and marketplaces the company operates in, the exact nature of the company’s business, and the company’s overall financial stability. For example, a relatively low acid-test ratio is less significant for a well-established business with long-term contract revenues, or for a business with very solid credit, so that it can easily access short-term financing if the need arises.
Drawbacks of the Acid-Test Ratio
As with virtually any financial metric, there are a number of limitations and potential drawbacks to using the quick ratio:
The acid-test ratio alone is not sufficient to determine the liquidity position of the company. Other liquidity ratios such as the current ratio or cash flow ratio are commonly used in conjunction with the acid-test ratio to provide a more complete and accurate estimation of a company’s liquidity position.
The ratio excludes inventory from the calculation because inventory is not generally considered a liquid asset. However, some businesses are able to quickly sell their inventory at a fair market price. In such cases, the company’s inventory does qualify as an asset that can readily be converted into cash.
The ratio does not provide information about the timing and level of cash flows, which are important factors in accurately determining a company’s ability to pay its obligations when they are due.
The acid-test ratio assumes that accounts receivable are easily and readily available for collection, but that may not actually be the case.
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