Acid-Test Ratio – Formula, Example and Importance

What Is the Acid-Test Ratio?

The acid-test ratio is a measure of the ability of a company to pay its short-term obligations on time. It is also commonly referred to as the quick ratio.

The acid-test ratio is used to evaluate financial statements to minimize the risk of misstatement or other fraud activities. The basic concept rests upon the concept that basic financial information alone cannot accurately measure the state of a company at any given time. Companies that develop effective policies and procedures for managing their liquidity risks will have healthier overall balance sheets.

Understanding Acid-Test Ratio

The acid-test ratio is a liquidity ratio that measures the ability of a company to pay its current bills and other liabilities. Unlike the current ratio, it does not include inventories because inventories can take a long time to convert into cash. It does, however, include accounts receivables since these can be collected quickly for cash.

An acid test ratio of less than 1 means that the company has more liabilities than assets. A low acid test ratio indicates a little risk that any company will default on its obligations to creditors. Companies with high acid test ratios tend to be illiquid, encouraging traders to bet against them rather than buy their stocks.

A high acid test ratio implies that a company is using excess cash to meet short-term cash needs rather than invest it in growing the business; it usually implies an overly optimistic view of the company’s ability to generate revenue in the future and an overly pessimistic view of its creditworthiness.

How to Calculate the Acid-Test Ratio?

The Acid-test ratio is a measurement of a company’s ability to pay its short-term debt obligations. It denotes the relationship between the current assets and the current liabilities after deducting deferred taxes and preferred dividends. The numerator of the ratio represents quickly convertible, liquid, short-term assets.

Formula to calculate the Acid- Test Ratio:

Acid Test=  Cash+Marketable Securities+ Accounts receivable / Current Liabilities

The idea of the acid-test ratio is to look at the profitability of an investment compared to its current market capitalization, adjusted for transaction costs and income taxes. This ratio tells us how profitable an investment is relative to its current worth. Many investors look at big companies with huge profit margins as indicators of good investment performance. In contrast, smaller firms with more extensive profit goals may require a higher ratio to justify a purchase.

Acid-Test Ratio Example

To aid in understanding this ratio, it is useful to think of it as a percentage of revenue or costs.

For example, if you have a product that costs $100 to make and sells for $100 worth of revenue, the acid-test ratio should be 0.3. If the company instead sells for $200 and generates $200 of revenue, the ratio will be closer to 1.0.

Drawbacks of the Acid-Test Ratio

  • The acid-test ratio is the least sophisticated of the liquidity ratios. Using it alone does give an accurate picture of a firm’s financial condition, but its limitations should be understood. For this reason, other ratios – such as the current ratio or cash flow ratio – are used in conjunction with it to provide a full accounting.
  • The acid-test ratio excludes inventory from the calculation because inventory is not cash-flow generating.
  • This ratio does not provide information about when and how much cash will be available for distributions, which are important factors in accurately determining its ability to pay its obligations when they are due.
  • The acid-test ratio may overestimate the real value of accounts receivable because some accounts will be extremely difficult to collect.
  • The possibility that the ratio may be excessively influenced by day-to-day statistics involving change orders and other temporary factors. Such factors may hide important long-term trends in the company’s liquidity. 
  • The lack of a universally accepted definition of liquidity is another drawback of the acid-test ratio. Historically, it has been used to describe any financial position liquid at December 31st but not necessarily liquid at any other time within the year.

How to Calculate the Acid-Test Ratio?

The acid-test ratio is a simple measure of a company’s ability to pay its liabilities. It also can be useful in analyzing the financial health of a company. For this, you will need to use the balance sheet and state the acid-test ratio as a single number, or you may include it on your financial statement presentation.

It is calculated by dividing the value of a company’s inventory by its total current liabilities.

Importance of the acid-test ratio

  • A good acid test ratio indicates that a company will satisfy all bank requirements, including regulatory requirements and Treasury regulations, within 90 days of receiving financing.
  • A company’s acid-test ratio provides an important clue to future earnings potential. If the current ratio is greater than 1, a company appears to have enough quick assets (cash and short-term investments) to meet its short-term liabilities. This enables the company to meet its obligations quickly. It also allows it to keep doing business without risking the loss of long-term assets (property, equipment, inventory).

What’s the Difference Between Current and Acid-Test Ratios?

The current and acid-test ratios are two different financial measures of a company’s ability to pay dividends and interest on its debt. With the current ratio, a company’s short-term ability to pay off debt is determined by dividing its current assets without inventories by its current liabilities. The acid-test ratio is a variation of the current ratio, with the difference being that the latter does not include items such as inventory.

The acid-test ratio considers the amount of a firm’s assets that can be converted in cash within 90 days rather than one year, which is the required time for the current ratio.

What Does the Acid-Test Ratio Tell You?

The acid-test ratio tells you how much debt a company has relative to its cash flow. And it tells you how much cash flow a company needs to continue buying assets and increasing its earnings per share over time.

A ratio above 1 means the company can buy more assets and keep paying off its debt faster; a ratio below 1 means it takes longer to pay off its debt and should be watched carefully. Lower ratios may indicate healthier finances, but they also mean more risk since a company might not withstand rapid changes in market conditions.

Is a High Acid Test Ratio Good?

A high acid test ratio is good for a company, usually when sales grow faster than its debts. It may mean that the company is growing without borrowing money or because it holds onto its cash.

However, if the ratio is too high and the company is growing quickly. Companies with a high acid-test ratio are easily meeting their financial obligations and are able to convert receivables into cash quickly. It is usually a sign that the company is experiencing strong top-line growth.

How Can I Improve My Acid Test Ratio?

Following are the ways which can help to improve the Acid Test Ratio:

1. Pay Off Liabilities Quickly

One of the best ways to improve your acid test ratio is by lowering current liabilities. An easy way to do this is to pay off creditors quickly and negotiate for a longer repayment term on your loans.

2. Increase Inventory Turnover & Sales

When a business experiences better inventory turnover, they experience increased sales and can meet their current short-term obligations more quickly. This results in more cash available for the business to make future investments in new products.

3. Reduce Invoice Collection Period

If you decrease the days it takes you to collect payments, you’ll get more cash in your business. That will help improve your acid ratio. Consistently collecting accounts receivable within 30 days will directly and positively impact your business’s AC acid test ratio.