What is Acid Test Ratio?
The acid test ratio is a measure of a company’s short-term liquidity, indicating its capacity to pay off current commitments using just its most liquid assets. It is calculated by dividing the sum of cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities.
The understanding of the acid test ratio is very important as it shows the company’s potential to convert its assets into cash very quickly in order to satisfy its current liabilities. If an entity has an adequate level of liquid assets to cover its current liabilities, then it doesn’t need to liquidate any of its long-term assets to meet its current obligations. This point is of paramount importance since most businesses rely on long-term assets to generate additional revenue.
Acid Test Ratio Formula
Another formula that is more popularly used calculates the acid test ratio first by deducting inventory from the total current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and then dividing the value by the total current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more. Inventory is excluded in this formula because it is not considered to be a rapid cash convertible. Mathematically it is represented as,
Examples
Below are some examples to understand the concept in a better manner.
Example #1
The following are the current assets and current liabilities of ABC Limited:
- Acid test ratio = ($2,500 + $12,500) / ($12,500 + $1,500 + $500)
- = 1.03
Example #2
The following are the current assets and current liabilities of Apple Inc. for the period ending 29 September 2018:
Calculate the acid test ratio of Apple Inc for the period ending 29 September 2018:
- = ($25,913 + $40,388 + $48,995 + $12,087) / ($55,888 + $20,748 + $40,230)
- = 1.09
Interpretation
- If the acid test ratio of an entity is greater than 1.0, then the entity is considered to be financially secure and sufficiently capable of meeting its short-term liabilities. This ratio is a more conservative measure than the popularly used current ratio as it excludes inventory, which is considered to take longer to convert into cash.
- As a thumb rule, a low or decreasing trend witnessed in acid test ratio usually indicates that an entity may be having weak top-line growth, struggling to manage working capitalManage Working CapitalWorking Capital Management refers to the management of the capital that the company requires for financing its daily business operations. It is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc.read more owing to lower creditor period or higher receivable period.
- On the other hand, a high or increasing trend in acid test ratio generally means that the entity is having strong top-line growth, quickly able to convert receivables into cash, and comfortable in its financial obligation coverage.
Apple’s Example
Now let us take the real-life example in excel of Apple Inc.’s published financial statement for the last four accounting periodsAccounting PeriodsAccounting Period refers to the period in which all financial transactions are recorded and financial statements are prepared. This might be quarterly, semi-annually, or annually, depending on the period for which you want to create the financial statements to be presented to investors so that they can track and compare the company's overall performance.read more.
You can easily calculate the ratio in the template provided.
Based on the publicly available financial informationFinancial InformationFinancial Information refers to the summarized data of monetary transactions that is helpful to investors in understanding company’s profitability, their assets, and growth prospects. Financial Data about individuals like past Months Bank Statement, Tax return receipts helps banks to understand customer’s credit quality, repayment capacity etc.read more of Apple Inc. we can calculate the ratio for the accounting years 2015 to 2018.
The result will be:-
From the above table, it can be seen that the acid test ratio of Apple Inc. has been continuously greater than 1.0 during the above mentioned period, which is a positive sign for any company as it signifies a comfortable liquidity position.
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