What it is:
The acid-test ratio is a measure of how well a company can meet its short-term financial liabilities.
How it works/Example:
Also known as the quick ratio, the acid-test ratio can be calculated as follows:
A common alternative formula is:
The is a more conservative version of another well-known liquidity metric -- the current ratio. Although the two are similar, the Acid-Test ratio provides a more rigorous assessment of a company's ability to pay its current liabilities. It does this by eliminating all but the most liquid of current assets from consideration. Inventory is the most notable exclusion, because it is not as rapidly convertible to cash and is often sold on credit. Some analysts include inventory in the ratio, though, if it is more liquid than certain receivables.
To demonstrate, let's assume this information was pulled from the balance sheet of our theoretical firm -- Company XYZ:
|Marketable Securities||$10,000||Accrued Expenses||$20,000|
|Accounts Receivable||$40,000||Notes Payable||$5,000|
|Inventory||$50,000||Current Portion of Long-Term Debt||$10,000|
|Total Current Assets||$160,000||Total Current Liabilities||$65,000|
Using the primary quick ratio formula and the information above, we can calculate Company XYZ's Acid-Test ratio as follows:
($60,000 + $10,000 + $40,000) / $65,000 = 1.7
This means that for every dollar of Company XYZ's current liabilities, the firm has $1.70 of very liquid assets to cover those immediate obligations.
Why it matters:
Obviously, it is vital that a company have enough cash on hand to meet accounts payable, interest expenses, and other bills when they become due. The higher the ratio, the more financially secure a company is in the short term. A common rule of thumb is that companies with a Acid-Test or quick ratio of greater than 1.0 are sufficiently able to meet their short-term liabilities.
In general, low or decreasing acid- test ratios generally suggest that a company is over-leveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly. On the other hand, a high or increasing acid-test ratio generally indicates that a company is experiencing solid top-line growth, quickly converting receivables into cash, and easily able to cover its financial obligations. Such companies often have faster inventory turnover and cash conversion cycles.
Like most other measures, acid-test ratio does have its potential drawbacks. To begin, analysts commonly point out that it provides no information about the level and timing of cash flows, which are what really determine a company's ability to pay liabilities when due. The acid-test ratio also assumes that accounts receivable are readily available for collection, which may not be the case for many companies. Finally, the formula assumes that a company would liquidate its current assets to pay current liabilities, which is not always realistic, considering some level of working capital is needed to maintain operations.
It is also important to understand that the timing of asset purchases, payment and collection policies, allowances for bad debt, and even capital-raising efforts can all impact the calculation and can result in different acid-test ratios for similar companies. Capital needs that vary from industry to industry can also have an effect on acid-test ratios. For these reasons, liquidity comparisons are generally most meaningful among companies within the same industry.