What is the Acid Test Ratio?
The acid test ratio measures 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.
Understanding the acid test ratio is very important as it shows the company’s potential to quickly convert its assets into cash to satisfy its current liabilities. For example, suppose an entity has an adequate liquid asset to cover its current liabilities. In that case, it does not need to liquidate any of its long-term assets to meet its current obligations. This is paramount since most businesses rely on long-term assets to generate additional revenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions..
Table of contents
- The acid test ratio measures a company’s short-term liquidity, focusing on its ability to meet current obligations using highly liquid assets.
- Calculate the ratio by dividing the sum of cash, cash equivalents, marketable securities, short-term investments, and current accounts receivables by total current liabilities.
- The acid test ratio demonstrates a company’s ability to convert assets into cash to fulfill current liabilities quickly.
- An acid test ratio above 1.0 indicates financial stability and sufficient capability to meet short-term obligations. It is a more conservative measure than the current ratio, which includes inventory that takes longer to convert into cash.
Acid Test Ratio Formula
Acid Test Ratio = (Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivables) / Total Current Liabilities
Another more popular formula 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. and dividing the value by the 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.. Inventory is excluded in this formula because it is not considered a rapid cash convertible. Mathematically it is represented as: –
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Video Explanation of Acid Test Ratio
Below are some examples to understand the concept in a better manner.
The following are the current assets and current liabilities of ABC Ltd.: –
- Acid test ratio = ($2,500 + $12,500) / ($12,500 + $1,500 + $500)
- = 1.03
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
- If an entity’s acid test ratio exceeds 1.0, it is considered financially secure and sufficiently capable of meeting its short-term liabilities. In addition, this ratio is a more conservative measure than the popularly used current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities 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 the acid test ratio usually indicates that an entity may have weak top-line growth and struggle 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. due to a lower creditorCreditorA creditor refers to a party involving an individual, institution, or the government that extends credit or lends goods, property, services, or money to another party known as a debtor. The credit made through a legal contract guarantees repayment within a specified period as mutually agreed upon by both parties. period or higher receivable period.
- On the other hand, a high or increasing trend in acid test ratio generally means that the entity has strong top-line growth, can quickly convert receivables into cash, and is comfortable in its financial obligation coverage.
Now let us take the real-life example in Excel of Apple Inc.’s published financial statementFinancial StatementFinancial statements are written reports prepared by a company's management to present the company's financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels. 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..
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. 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 period mentioned above, which is a positive sign for any company as it signifies a comfortable liquidity position.
Frequently Asked Questions (FAQs)
The acid test ratio, also known as the quick ratio, measures a company’s ability to pay off its current liabilities using its most liquid assets. It excludes inventory from the calculation, unlike the current ratio, which includes it. Therefore, the acid test ratio provides a more conservative measure of short-term liquidity.
Investors, creditors, and analysts commonly use the acid test ratio to assess a company’s short-term financial health and liquidity. It helps determine if a company has enough liquid assets (such as cash and cash equivalents) to cover its immediate obligations, such as debt payments and operational expenses.
While the acid test ratio provides valuable insights, it has certain limitations. It does not consider the timing of cash inflows or the company’s ability to generate sales. Moreover, it may not be applicable to all industries, particularly those heavily reliant on inventory or where quick asset conversion is difficult. Additionally, different companies may have varying interpretations of what qualifies as a liquid asset, affecting the ratio’s accuracy for comparison.
This article is a guide to Acid Test Ratio and its meaning. We discuss the formula for the acid test ratio along with an acid test ratio example. You may learn more about financial statement analysis from the following articles: –