Formula to Calculate Acid Test Ratio
Acid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.
It can be calculated using two methods
Method 1
Mathematically it is represented as,
- Step 1: Firstly, all the liquid assets like cash, cash equivalents, short-term investments or marketable securities and current accounts that can be liquidated within 90 days are identified from the balance sheet and then added up.
- Step 2: Now, the acid test ratio is computed by dividing the summation of the liquid assets in Step 1 by the total current liabilities from the balance sheet.
Method 2
Another formula that is more popularly used calculates the acid test ratio first by deducting inventory from the total current assets and then diving the value by the total current liabilities. Inventory is excluded in this formula because it is not considered to be a rapid cash convertible. Mathematically it is represented as,
- Step 1: Firstly, identify the sum of all the current assets and the inventory from the balance sheet and then deduct the inventory from the total current assets.
- Step 2: Now, the acid test ratio computed by dividing the value in Step 1 by the total current liabilities from the balance sheet.
As can be seen from above, the acid test ratio assesses the liquidity position of an entity by computing how well the most liquid assets can cover the current liabilities.
Examples of Acid Test Ratio Formula
Below are some of the examples to understand Acid Test Ratio 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:
- Acid test ratio = ($25,913 + $40,388 + $48,995 + $12,087) / ($55,888 + $20,748 + $40,230)
- = 1.09
Acid Test Ratio Calculator
You can use the following Acid Test Ratio Calculator.
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Relevance and Uses
The understanding of the acid test ratio is very important as it shows an entity’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.
- 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 to meet their short-term liabilities. The acid test 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 capital 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.
Calculate Acid Test Ratio in Excel (with excel template)
Now let us take the real-life example in excel of Apple Inc.’s published financial statement for the last four accounting periods.
You can easily calculate the Acid Test ratio in the template provided.
Based on publicly available financial information the Acid test ratio of Apple Inc. can be calculated for the accounting years 2015 to 2018.
Here we will use the Acid Test Ratio Formula = (Cash + Cash equivalents + Marketable securities + Current accounts receivables) ÷ Total current liabilities
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.
Acid Test Ratio Formula Video
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This has been a guide to Acid Test Ratio Formula, here we discuss its uses and calculation along with practical examples of Acid Test Ratio Formula. Here we also provide you with the Acid Test Ratio Calculator with a downloadable excel template.
