Acid Test Ratio Definition, Formula & Calculation

Similarly, if you are aware of any accounts receivable that are not expected to be collected on time, then consider excluding them from the calculation. Also, do not include inventory in the calculation, since it can take a long time (if ever) to convert inventory into cash. Higher quick ratios are more favorable for companies because it shows there are more quick assets than current liabilities.

Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. For purposes of calculation, you only include securities that can be made liquid immediately or within the next year or so. Companies can take steps to improve their quick ratios by either reducing their liabilities or boosting their asset count. Quick ratios are useful only when they are compared to industry standards or trends for that sector. For example, the retail industry has a quick ratio value that is substantially lower than its current ratio. Quick ratio establishes a timeframe and places restrictions on the number of assets that can be included in calculations.

  1. Quick ratio establishes a timeframe and places restrictions on the number of assets that can be included in calculations.
  2. As you can see, the ratio is clearly designed to assess companies where short-term liquidity is an important factor.
  3. A business’ acid test ratio may increase or decrease significantly in the near future, so today’s acid test ratio should be interpreted with future impacts in mind.
  4. Therefore, the acid-test ratio can be considered a more reasonable tool for evaluating an organization’s liquidity than the current ratio.

When an acid test ratio is greater than one, it indicates the company’s liquid assets could cover up to that many times the liabilities. The acid-test ratio, or the quick ratio, is a type of liquidity ratio that measures a company’s ability to pay its short-term liabilities with assets that can be readily converted into cash. The quick ratio is the barometer of a company’s capability and inability to pay its current obligations.

How Is the Acid-Test Ratio Calculated?

As an example, suppose that company ABC has $100,000 in current assets, $50,000 of inventories and prepaid expenses of $10,000 owing to a discount offered to customers on one of its products. However, an acid-test ratio score that is extremely burn rate high can also mean idle inventory or cash lying around on its balance sheet. An acid-test ratio of less than one is a strike against a firm because it translates to an inability to pay off creditors due to fewer assets than liabilities.

What You Need to Calculate the Acid-Test Ratio

Inventory that takes a long time to convert into sales is useless to meet emergency obligations. At a quick glance, acid-test ratios are a measure of a firm’s capability to stay afloat and a function of its ability to quickly generate cash during times of stress. The reliability of this ratio depends on the industry the business you’re evaluating operates in, so like many other financial ratios, it’s best to use it when comparing similar companies. Let’s use the hypothetical balance sheet below to calculate the acid test ratio. It is not uncommon for certain industries to have ratios below 1, especially industries that hold a lot of inventory, such as retailers.

Acid-Test Ratio Calculator

Cash equivalents are certain short-term investments with a maturity term of up to 90 days. Current accounts receivable is also called net accounts receivable (reduced by the allowance for doubtful accounts), which estimates collectible accounts receivable. If a company’s asset test ratio is too low, lenders may be reluctant to offer financing to the company because insolvency risk is higher. With asset turnover and utilization improvement or turnaround methods, the company’s current assets can be increased, and a low acid-test ratio can be improved. But if a high ratio for the acid test is too high, the company may have too much idle cash that could bring higher returns (ROI) if used for strategic growth opportunities.

Interpreting the Acid-Test Ratio

It does not include assets that are hard to liquidate quickly, like most inventory. The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets. If a firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to sell off any long-term or capital assets.

Liquidity refers to the ability of a company to come up with the cash it needs as it needs it, an important aspect of the financial health of a business. The quick ratio is more conservative as it excludes inventory from the current assets. On the other hand, the current ratio includes all the items forming part of the company’s existing assets. Generally, a ratio of 1 or more indicates that the company has good financial health and can very well meet its current liabilities without selling its long-term assets. The current ratio is a less conservative measure than the acid-test ratio, because it includes inventory.

You can easily calculate the Acid-Test Ratio using Formula in the template provided. Electronic publishing companies may not print books, but they have some inventory. This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.

Solvency, although related, refers to a company’s ability to instead meet its long-term debts and other such obligations. By ordinary standards, a quick ratio of less than one is considered unhealthy. However, the retail industry’s low acid-test ratio is a mark of its robust inventory practices. That said, like all financial ratios, the acid test ratio should be considered in line with industry averages. The acid-test ratio compares the near-term assets of a company to its short-term liabilities to assess if the company in question has sufficient cash to pay off its short-term liabilities.

A company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay off its current liabilities without selling any long-term assets. An acid ratio of 2 shows that the company has twice as many quick assets than current liabilities. Sometimes company financial statements don’t give a breakdown of quick assets on the balance sheet. In this case, you can still calculate the quick ratio even if some of the quick asset totals are unknown.

With so much information out there to consider, it can be hard to even know where to begin. That’s why investors often rely on simple rules of thumb that help them get a rough sense of the health of a company, before diving in deeper. In this article, we will examine this helpful metric and explain how it can be an easy way to quickly gauge a company’s health. At the same time, we will also consider the limitations of this metric, and discuss why it needs to be interpreted carefully. It measures the ability of a business to pay their short-term liabilities with the assets available. When your company has better management of accounts payable and payments, it gains the ability to take early payment discounts offered by its vendors.

Companies with an acid-test ratio of less than 1.0 do not have enough liquid assets to pay their current liabilities and should be treated cautiously. If the acid-test ratio is much lower than the current ratio, a company’s current assets are highly dependent on inventory. The first thing to do is identify the balance of all the business’ quick assets accounts and the balance of its current liabilities. Current assets include any asset that can be reasonably converted into cash within one year.

This ratio is crucial for assessing a company’s ability to meet its short-term obligations without relying heavily on inventory sales. The acid-test ratio is the sum of the current assets to current liabilities. A current asset is the sum of a company’s assets, which can be converted into cash within 90 days.

Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments, and deferred tax assets. In order to understand and interpret the acid test ratio, it is important to compare the number from one company to other companies in the same industry. In most industries, the ideal number is close to and just above the number one. When an acid test ratio is less than one, the liabilities are higher than the company’s short-term assets.