What is the Acid Test Ratio?
The acid test ratio is the most stringent calculation of short-term liquidity. It compares a company’s quick assets to its current liabilities. For that reason, the acid-test ratio is also known as the quick ratio. It gauges a company’s liquidity by evaluating how well current assets can cover current obligations. Only the most liquid current assets are used when calculating the quick ratio. This means assets that can be converted to cash in 90 days or less. The acid test ratio is one of six basic computations used to estimate a company’s short-term liquidity. In other words, its ability to pay its debts when they come due. This reveals how much money a company has available to pay for each dollar of bills it owes.
A business should ideally have an acid-test ratio of at least 1:1. A corporation with an acid-test ratio of less than 1:1 should quickly seek to develop more quick assets. It can do so by offering discounts to stimulate sales, collecting on accounts receivable (perhaps with special terms for early payment), or requesting shareholders to invest more money in the company.
How to Calculate the Acid Test Ratio
The balance sheet contains all of the information required to determine the acid-test ratio. Current assets, or assets that can be converted into cash in less than a year: A company’s balance sheet will include the following items:
Acid Test Ratio = (Cash + Marketable Securities + Accounts receivable) / Current Liabilities
- 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. Marketable securities are traded on an open market with a known price and readily available buyers. For example, any stock on the New York Stock Exchange would be considered marketable security. This is because it can easily be sold to any investor when the market is open.
- AR (Accounts receivable) 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. They include short-term debt, accounts payable, accrued liabilities, and any other current debt.
Acid Test Ratio – A Closer Look
The acid test is a quick computation revealing whether a corporation is liquid enough to satisfy its short-term obligations. In the worst-case scenario, it may be necessary for the corporation to use all of its liquid assets to do so. As a result, a ratio larger than 1.0 is a favorable signal. Conversely, a value less than 1.0 may indicate danger ahead.
The acid-test ratio is one of the most stringent estimates of liquidity. This is because it does not include all of the elements used in the current ratio. For example, the current ratio assesses a company’s capacity to pay short-term liabilities (debt and payables) with short-term assets (cash, inventory, receivables). However, the acid test excludes inventory, which may take longer to dispose of. As a result, the acid-test ratio is a more cautious measure than the current ratio. From an investor’s perspective, firms having a ratio of less than one have insufficient liquid assets. They could encounter difficulty meeting their present debt commitments or payments. Clearly, they should be approached with caution and scrutiny. The acid test is a simple, yet revealing computation. Nevertheless, additional ratios that incorporate more balance sheet components, such as the current ratio, should be considered.
Acid Test Ratio – What It Tells You
Companies should ideally have a ratio of 1.0 or above. This indicates that they have enough liquid assets to cover all short-term debt commitments or bills. Other factors that influence the acid-test ratio include how long it takes a corporation to collect accounts receivable, the timing of asset purchases, and how bad-debt allowances are managed. Certain technology businesses may have high acid-test ratios, which is not necessarily a bad thing. Rather, it signifies that they have a lot of cash on hand.
A better ratio percentage is 2:1, which often implies sufficient cash to satisfy all obligations. Even with such a favorable ratio, timing issues can always come into play. For example, a big liability is due for payment within the next few days while the offsetting assets are not to be liquidated for another few weeks. Another concern arises when the ratio is exceptionally high, such as anything greater than 5:1. In this instance, a company has an overwhelming amount of liquid assets that are underutilized. As a result, it may make more sense to distribute excess assets to shareholders in the form of a dividend or stock buyback.
- Solvency indicator – If an entity’s acid test ratio exceeds 1.0, it is deemed capable of meeting its short-term responsibilities. Furthermore, because the calculation eliminates inventory, this ratio is a more conservative metric than the often-used current ratio. Inventory is not considered because it is thought to take longer to convert into cash.
- Trending down – A low or decreasing trend in the acid test ratio suggests that an entity may have weak top-line growth. As a result, they may struggle to manage working capital. This may be due to a shorter creditor term or a longer receivable period.
- Trending upward – A high or increasing trend in acid test ratio can indicate that the organization has strong top-line growth. As a result, it can swiftly convert receivables into cash and is secure in its financial obligation coverage.
Advantages of the Acid Test Ratio
All the information required to compute the acid-test ratio is present on an organization’s balance sheet. This is a significant advantage. This document is part of the financial statements and should be easily accessible, especially for publicly traded companies. Moreover, the calculation is straightforward and can be done on the back of a napkin if necessary.
Disadvantages of the Acid Test Ratio
Although the ratio is normally reliable, it can provide misleading information when a corporation has an unused line of credit. In this case, it may have little or no cash on hand but can use the funds in the line of credit to fulfill its bills. The same is true when a company is closely controlled by a wealthy shareholder. There is an ongoing likelihood that this party will provide the necessary funds to the company to keep it running. Even if the ratio implies that it is not particularly liquid.
When current liabilities cover a long period of time, the ratio can also be a poor predictor. Current obligations are defined as any liabilities that are due within the next year. As a result, a liability might appear in the calculation even though it is not due for payment until year-end. Quick assets by definition are convertible within 90 days. Current liabilities, however, are due within twelve months. Obviously, this can present an occasional mismatch.
Example of the Acid Test Ratio
Consider a business that has $30,000 in cash, $50,000 of marketable securities, and $320,000 of accounts receivable. These quick assets are offset by $200,000 of current liabilities. The calculation of its acid-test ratio is:
($30,000 Cash + $50,000 Securities + $320,000 Receivables) ÷ $200,000 Current liabilities = 2:1
On the surface, a 2:1 result appears that the firm can easily pay off its current liabilities. However, this may not actually be the case. The key issue is how long it will take for the organization to collect its outstanding receivables.
Frequently Asked Questions
What Is the Difference Between the Current Ratio and the Acid Test Ratio?
In the numerator of the acid-test or quick ratio, only the most liquid current assets are included. Instead, the current ratio considers total current assets, which include non-liquid things such as inventories.
What Is the Difference Between Liquidity and Solvency?
Liquidity refers to a company’s ability to meet short-term obligations promptly and on time. Ratios such as the acid test and current ratio aid in determining a company’s liquidity. Although related, solvency refers to a company’s capacity to meet its long-term loans and other such responsibilities. A corporation may be illiquid but solvent, or vice versa.
The Bottom Line
When reviewing a company’s financial statements, no single ratio will satisfy every situation. Include numerous ratios in your study and compare each ratio to organizations in the same industry. Companies can compare their acid test ratios to the industry average. This will help them to see how they compare to competitors and other industry participants. Companies that do not have liquidity issues can concentrate on their competitive strategy for increasing market share. They are not distracted about losing corporate control due to insolvency or bankruptcy.
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