Acid-Test Ratio Demystified

The acid-test ratio, also referred to as quick ratio or liquidity ratio, is a measure of the ability of a company or business to pay off its short-term liabilities using its current (or liquid) assets. In short, it is the measure of the liquidity of a business.

The formula to calculate acid-test ratio is liquid assets (cash, cash equivalents, marketable securities, current accounts receivables, short-term investments) divided by current liabilities. Another method to calculate includes current assets minus inventories minus prepaid expenses divided by current liabilities.

The acid-test ratio highlights a relationship between current assets (cash and accounts receivables) and current liabilities on a balance sheet.

Current assets relate to assets which can be converted to cash within 90 days. This may include cash, treasury bills, mutual fund investments, accounts receivables (from vendors or customers), etc.

Current liabilities may include salaries payable, accounts payable (to suppliers), deferred taxes, short-term debts, accrued expenses (example, monthly rental payments), etc.

The acid-test ratio provides an indication of a company’s financial health. Generally, a ratio of one or higher is considered to be normal and implies that the company is in a position to address short-term liabilities. A very high or increasing acid-test ratio, however, underlines that a company or business has faster inventory turnover and cash conversion cycles.

While both, the acid-test ratio and current ratio, measure a company’s liquidity, there is a slight difference between the two. The acid-test ratio only takes into account the quick assets, which include the current assets that can be converted into cash quickly. This includes cash, cash equivalents and accounts payable. However, the current ratio takes into consideration all the current assets, including inventories and prepaid expenses.

Acid-test ratio helps an investor in terms of choosing the right company for investment. However, acid-test ratio cannot be considered as the sole indicator of a company’s liquidity as it does not consider time periods.

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