The Acid-Test Ratio, also known as the quick ratio, is a liquidity ratio that measures how sufficient a company’s short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations. This guide will break down how to calculate the ratio step by step, and discuss its implications. To calculate the acid-test ratio of a company, divide a company’s current cash, marketable securities, and total accounts receivable by its current liabilities. Current assets and current liabilities are short-term assets and short-term liabilities on a company’s balance sheet likely convertible to cash within a year. The acid test ratio is important because it measures liquidity and a company’s ability to pay its bills and other short-term obligations with short-term assets quickly convertible to cash.
For example, RMA Statement Studies provides five-year benchmarking data, including financial ratios for small and medium-sized companies. The Acid Test Ratio, or “quick ratio”, is used to determine if the value of a company’s short-term assets is enough to cover its short-term liabilities. Along the same lines, purchases for the business that might have added to the liabilities and account payable figures can be delayed to the next quarter or financial year to boost quick ratios. Another strategy is to invoice pending orders and inventory so that they become accounts receivables in accounting books and can be added to current assets. Remember a quick ratio only considers current assets that can be liquidated in the short-term.
How to Perform Liquidity Analysis with the Acid Test Ratio
A cash flow budget is a more accurate tool to assess the company’s debt commitments. While figures of one or more are considered healthy for quick ratios, they also vary based on sectors. It is calculated as a sum of all assets minus inventories divided by current liabilities. Generally, a score of one or greater for the ratio is considered good because it implies that the firm can fulfill its debt commitments in the short-term. With an acid test ratio of at least 1, a company should have adequate liquidity to pay current liabilities when payments are due.
Technology companies are another case in point because they have low fixed inventory numbers. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The general rule of thumb for interpreting the acid-test ratio is that the higher the ratio, the less risk attributable to the company (and vice versa).
Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits. As the company began distributing dividends to shareholders, its quick ratio has mostly stabilized to normal levels of around 1. Manufacturing companies can reduce rework and find potential product defects earlier in the manufacturing process with ERP-integrated smart shop floor software and sensors (IoT) with built-in machine learning alerts.
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Beyond that, we discuss some levers financial management can use to improve their company’s acid-test ratio results for better financial health. A company with a low current or quick ratio should likely proceed with some degree of caution, and the next step would be to determine how much more capital and how quickly it could be obtained. In particular, a current ratio below 1.0x would be more concerning than a quick ratio below 1.0x, although either ratio being low could be a sign that liquidity might soon become a concern. However, this is not a bad sign in all cases, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid-test ratios without necessarily being in danger. The acceptable range for an acid-test ratio will vary among different industries, and you’ll find that comparisons are most meaningful when analyzing peer companies in the same industry as each other.
- In Year 1, the current ratio can be calculated by dividing the sum of the liquid assets by the current liabilities.
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- Quick ratio establishes a timeframe and places restrictions on the number of assets that can be included in calculations.
- Retail stores, for example, may have very low acid-test ratios without necessarily being in danger.
Inventory is deducted from the overall figure for current assets, leading to a low figure for the numerator and, therefore, low acid-test ratio figures. In Year 1, the current ratio can be calculated by dividing the sum of the liquid assets by the current liabilities. The acid-test ratio compares the near-term assets of a company to its short-term liabilities to assess if the company in question has sufficient cash to pay off its short-term liabilities. Liquidity corresponds with a company’s ability to immediately fulfill short-term obligations. Ratios like the acid test and current ratio help determine a firm’s liquidity.
Acid Test Ratio
Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. The Acid-Test Ratio is calculated as a sum of all assets minus inventories divided by current liabilities. As an example, suppose that company ABC has $100,000 in current assets, $50,000 of inventories and prepaid expenses of $10,000 owing to a discount offered to customers on one of its products. By ordinary standards, a quick ratio of less than one is considered unhealthy.
Calculating the Acid Test Ratio
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What You Need to Calculate the Acid-Test Ratio
The current ratio, for instance, measures a company’s ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The acid-test ratio is more conservative than the current ratio because it doesn’t include inventory, which may take longer to liquidate. Ideally, companies should have a ratio of 1.0 or greater, meaning the firm has enough liquid assets to cover all short-term debt obligations or bills.
How to Calculate Acid Test Ratio
The higher the acid test ratio number, the more cash and near-cash liquid assets a company has. The acid-test ratio and current ratio are two frequently used metrics to measure near-term liquidity risk, or a company’s ability to quickly pay off liabilities coming due in the next twelve months. Compared to the current ratio, the acid test ratio is a stricter liquidity measure due to excluding inventory from the calculation of current assets. Firms with a ratio of less than 1 are short on liquid assets to pay their current debt obligations or bills and should, therefore, be treated with caution. The quick ratio uses only the most liquid current assets that can be converted to cash within 90 days or less. Companies can benchmark acid test ratios in their industry to the industry average to assess how they’re performing relative to competitors and other industry participants.
There is no single, hard-and-fast method for determining a company’s acid-test ratio. Some analysts might include other balance sheet line items not included in this example, and others might remove the ones used here. So, it is important to understand how data providers arrive at their conclusions before using the metrics given to you. Quick ratios are useful only when they are compared to industry standards or trends for that sector.
