An acid test ratio, also known as quick ratio, is used to calculate whether the company will be able to meet its current liabilities with the short-term assets it has. Although working capital ratio is used for the same purpose, it includes inventories in short-term assets as well, which might not be easy to convert into cash. The acid test ratio formula, which does not include inventories is thus, a far more stricter test of determining a company's current financial capability to meet its short-term liabilities.
Formula for Acid Test Ratio
In accounting, the acid test ratio formula is mathematically presented as follows:
Cash + Accounts Receivable + Short-term Investments/Current Liabilities
There is an alternative to this formula as well, which is:
Current Assets - Inventory/Current Liability
Example
To make it more clear, let's take an example of a fictitious company ABC. In the balance sheet of ABC, the current assets are:
- Cash: USD 50,000
- Accounts receivable: USD 30,000
- Marketable securities: USD 5000
- Inventory: USD 30,000
Current liabilities are:
- Accounts payable: USD 20,000
- Accrued expenses: USD 15,000
- Notes payable: USD 3,000
- Long-term debt's current portion: USD 7,000
Now, company ABC's acid test ratio will be total current assets from which inventory is subtracted, divided by total current liabilities, i.e., (USD 50,000 + USD 30,000 + USD 5,000 + USD 30,000) - USD 30,000 / (USD 20,000 + USD 15,000 + USD 3,000 + USD 7,000) = 1.88
With the acid test ratio as 1.88, the company XYZ has USD 1.88 of short-term liquid assets to meet every USD 1 of current liabilities.
Interpretation
If the acid test ratio of an organization is less than one, it means that it does not have enough current assets to meet its current liabilities. That is why, it is very important for companies to maintain a high ratio, i.e., more than one. A ratio which is less than one or is decreasing, shows that the company is either paying bills very quickly or is collecting receivables very slowly or is unable to grow sales. A high ratio shows that the company has a fast conversion cycle and a good inventory turnover too.
Another thing that companies should consider is that in case the acid test ratio is very low, compared to the working capital ratio, it indicates that the share of inventory in current assets of the company is huge. Since inventory cannot be that easily converted to cash, the company has to be really cautious about its current financial position.
Acid test ratio formula, like most other financial ratio formulas of accounting, has its own drawbacks. Firstly, it gives no information about the cash flow timings and without this information, it is impossible to determine the ability of the company to pay liabilities. Secondly, it is based on the assumption that accounts receivable are available for collection, this however may not be true in reality for many companies. Thirdly, another assumption of the formula that a company would consume most of its current assets to pay for its current liabilities, is not possible in reality, as companies do need some working capital to carry on with its operations. Lastly, timing of the purchase of assets, payment policy, collection policy, allowance of bad debt, may vary from company to company so any comparison using acid test ratios of the liquidity of companies, might not be precise, unless and until the companies belong to the same industry.
