Acid Test Ratio

Updated on May 7, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

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 revenue.

Key Takeaways

  • 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

What is Acid Test Ratio

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Another more popular formula calculates the acid test ratio first by deducting inventory from the total current assets and dividing the value by the current liabilities. Inventory is excluded in this formula because it is not considered a rapid cash convertible. Mathematically it is represented as: –

Acid Test Ratio Formula 1

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Video Explanation of Acid Test Ratio

 

Examples

Below are some examples to understand the concept in a better manner.

You can download this Acid Test Ratio Formula Excel Template here – Acid Test Ratio Formula Excel Template
Example #1

The following are the current assets and current liabilities of ABC Ltd.: –

acid test ratio formula example 1
  • 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: –

Acid Test Ratio Example 2

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 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 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 the acid test ratio usually indicates that an entity may have weak top-line growth and struggle to manage working capital due to a 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 has strong top-line growth, can quickly convert receivables into cash, and is 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 period.

You can easily calculate the ratio in the template provided.

Example 1

Based on the publicly available financial information of Apple Inc., we can calculate the ratio for the accounting years 2015 to 2018.

Example 1-1

The result will be:-

Example 1-2

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)

1. What is the difference between the acid test and current ratios?

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.

2. What is the application of the acid test ratio?

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.

3. What are the limitations of the acid test ratio?

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.

Recommended Articles

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: –

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