Acid Test Ratio

Image: Moneybestpal.com

What is the acid test ratio?

The quick ratio, sometimes referred to as the acid test ratio, is a liquidity ratio that assesses how well a business can use its most liquid assets to satisfy its current creditors. Compared to the current ratio, which also takes inventory into account, it is a more cautious indicator of liquidity. 

While a low ratio raises the possibility of liquidity issues, a high ratio shows that a corporation has adequate cash and cash equivalents to cover its short-term obligations.

Why is the acid test ratio important?

Compared to the current ratio, the acid test ratio offers a more accurate picture of a company's liquidity condition, which makes it significant. The current ratio's component, inventory, might not be quickly convertible to cash, particularly if the business is in a seasonal or slow-moving industry. 

The acid test ratio concentrates on the most liquid assets that can be promptly utilized to settle current liabilities by eliminating inventories. This provides a more accurate picture of a company's ability to pay its bills right away without depending on inventory sales or outside funding.

What is the formula for the acid test ratio?

The formula for the acid test ratio is:

Acid test ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable) / Current liabilities

The balance sheet of the business contains all of these items. The most liquid current assets on the balance sheet are cash and cash equivalents, which include short-term deposits, money market funds, bank accounts, and treasury bills. 

Financial products like stocks, bonds, and mutual funds that are easily sold or converted into cash are known as marketable securities. Amounts owing by clients to the business for products or services provided on credit are known as accounts receivable. 

Current liabilities include debts like accounts payable, short-term loans, accumulated expenses, and taxes that must be paid within a year.

Marketable securities, accounts receivable, and cash and cash equivalents must all be added up and divided by current liabilities in order to determine the acid test ratio.

 

For example, if a company has $10,000 in cash and cash equivalents, $5,000 in marketable securities, $15,000 in accounts receivable, and $20,000 in current liabilities, its acid test ratio would be:

Acid test ratio = ($10,000 + $5,000 + $15,000) / $20,000
Acid test ratio = $30,000 / $20,000
Acid test ratio = 1.5

This indicates that for every $1 in current liabilities, the corporation has $1.5 in liquid assets. An acid test ratio of one or more is generally regarded as satisfactory since it shows that the business can pay its current creditors using its liquid assets. Nevertheless, the ideal acid test ratio may differ based on the sector and type of organization.

How to calculate the acid-test ratio?

The formula for calculating the acid-test ratio is:

Acid-test ratio = (Cash and cash equivalents + Marketable securities + Accounts receivable) / Current liabilities

The company's balance sheet contains all of the aforementioned items. The balance sheet's most liquid assets are cash and cash equivalents, which include T-bills, savings accounts, and term deposits with maturities of less than three months. 

Marketable securities, which include stocks, bonds, and mutual funds, are short-term investments that are readily sold on the open market. Customers' outstanding payments for goods or services that were provided on credit are known as accounts receivable. 

Accounts payable, short-term debt, accrued expenses, and taxes due are examples of current liabilities that the business must pay off within a year.

To calculate the acid-test ratio, we need to add up the cash and cash equivalents, marketable securities, and accounts receivable, and divide them by the current liabilities. 

For example, if a company has $10,000 in cash and cash equivalents, $5,000 in marketable securities, $15,000 in accounts receivable, and $20,000 in current liabilities, its acid-test ratio would be:

Acid-test ratio = ($10,000 + $5,000 + $15,000) / $20,000

Acid-test ratio = $30,000 / $20,000

Acid-test ratio = 1.5

This means that the company has $1.5 of liquid assets for every $1 of current liabilities.

Examples of acid-test ratio

Now let us examine a few instances of acid-test ratios in various sectors. For manufacturing enterprises, it is 1.39, for software companies it is 2.09, while for retail establishments it is an average of 0.53. The disparity in type and liquidity between their current liabilities and assets is shown in these data.

Retail establishments, for example, typically have low acid-test ratios due to extensive inventory that is not factored into the equation. When it comes to selling or potential value loss over time, inventory is typically less liquid than cash or marketable securities. A significant portion of retail stores' accounts payable to suppliers are also due quickly.

Conversely, manufacturing firms typically have more accounts receivable and less inventory, which results in a greater acid-test ratio. Manufacturing businesses frequently give their clients credit for their goods, which raises their accounts receivable. To prevent cash flow issues, they must also collect their receivables in a reasonable amount of time.

Because they have a lot of cash and marketable securities and relatively little inventory, software companies typically have the highest acid-test ratios. Software businesses typically offer their goods online or through subscriptions, which immediately bring in money. Additionally, because they do not depend on vendors or tangible things, their accounts payable are modest.

Limitations of acid-test ratio

The acid-test ratio is a useful indicator of a company's liquidity and financial health, but it also has some limitations that need to be considered:

• If a company has accounts receivable that take longer than typical to collect or current liabilities that are due but do not require immediate payment, the acid-test ratio may not provide a fair picture of the company's financial situation. For example, a company's acid-test ratio may be exaggerated and misleading if it has a significant amount of deferred revenue that will not be recognized until subsequent periods or overdue receivables that are unlikely to be recovered.
• The quality or profitability of a company's assets or liabilities are not taken into consideration by the acid-test ratio. An organization's acid-test ratio might not accurately represent its actual performance or potential, for instance, if it has a large amount of cash and marketable securities that are underperforming or losing value, or if it has a large amount of debt that has restrictive covenants or high-interest rates.
• The cash flows and seasonality of a business are not taken into account by the acid-test ratio. The acid-test ratio of a company may exhibit substantial fluctuations from quarter to quarter and may not accurately reflect its typical liquidity level, particularly if the company has a seasonal or cyclical industry that generates higher cash inflows during specific periods.
• The industry or market norms or expectations regarding a company's liquidity status are not taken into consideration by the acid-test ratio.  An organization's acid-test ratio might be lower than in other industries, but it would still be seen as acceptable by peers and stakeholders if it serves a market that demands a high degree of working capital or has a low turnover rate of inventories or receivables.

FAQ

The Acid-Test Ratio is also known as the Quick Ratio because it measures a company’s ability to quickly cover its short-term liabilities with its most liquid assets.

The Acid-Test Ratio is more conservative than the Current Ratio because it excludes inventory, which may be difficult to quickly convert into cash.

An Acid-Test Ratio of less than 1.0 indicates that a company might struggle to meet its short-term obligations.

Yes, a high Acid-Test Ratio could indicate that cash has accumulated and is idle rather than being reinvested, returned to shareholders, or otherwise put to productive use.