Acid Test Ratio Meaning, Formula, Calculation, Interpretation

The resulting ratio is easy to analyse, and the stakeholders can quickly analyse the company’s position. A higher ratio means that those assets would be enough to cover the liabilities with money left over. For example, an acid test ratio of 2.0x means that the business could cover by where’s my amended return two times. Obviously the liabilities would not have to be paid more than once — the fact that the business could potentially come up with twice as much cash as it needs provides a cushion, or a margin for error. Higher acid test ratios indicate stronger, or more favorable, liquidity.

It shows the company’s ability to meet short-term debt and financial obligations. It is also an indicator of the growth potential of the company and how it is performing in terms of its finances. While a company with a quick ratio below 1 shows a sign of poor financial health and could indicate its inability to pay off the current debts as and when they become due for payment.

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This does not indicate that they are financially not liquid to pay off the current debts. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting. This business’ quick assets are cash and cash equivalents, which has a balance of $100,000, and accounts receivable, which has a balance of $200,000.

It’s important to include multiple ratios in your analysis and compare each ratio with companies in the same industry. 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. An acid-test ratio is one measure of a company’s financial health at one moment in time.

The current ratio is a less conservative measure than the acid-test ratio, because it includes inventory. When the inventory owned by a business takes a long time to liquidate, the current ratio can be misleading, because it assumes that the inventory can be readily converted into cash. The acid-test ratio makes no such assumption, since it excludes inventory from the calculation. A company’s liquidity measured by the current ratio normally depends on how its inventory is converted into cash in a specific time period. This is a good sign for investors, but an even better sign to creditors because creditors want to know they will be paid back on time. It only requires information regarding the current liabilities and assets, which can be seamlessly obtained from the organisation’s financial statements.

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If metal failed the acid test by corroding from the acid, it was a base metal and of no value. Because this is an industry with a large inventory, a different formula is used to figure the acid test ratio. At the other extreme, an acid test ratio that is too high could indicate that a company is holding on too tightly to its cash when it could be using it to fuel business growth.

All stakeholders, especially the investors and creditors, are particularly interested in a firm’s acid test ratio. For the creditors, it determines how well-equipped the firm is to make payments and fulfil its financial obligations. They may even tailor the credit period to the organisation’s favour if the firm shows an excellent quick ratio. As for the investors, the ideal ratio indicates that the organisation is on track with its goals, is taking up growth opportunities, and is financially healthy. Of this, Rs.3,40,000 were its inventories, and Rs. 60,000 amounted to the prepaid expenses. Some may include that the acid test shows the liquidity positions of a company.

What Is the Difference Between Liquidity and Solvency?

Electronic publishing companies may not print books, but they have some inventory. The result of the calculation is expressed as a multiple, with the number followed by an ‘x’, such as 2.5x. When said aloud, the result is read as ‘2.5 times’, meaning that the numerator is 2.5 times as large as the denominator. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

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. This ratio involves dividing the current assets (minus inventories) due to their high liquidity (can be easily converted into cash) by the current liabilities. One of the uncertainties that investors face while investing in a company is that the company might encounter economic difficulties and end up breaking. Since the future of their investment depends on the future of the company, investors like to know if a company is likely to get into difficulties and they use the quick ratio to find out.

Acid-Test Ratio Example

A ratio of 1 signifies that the quick assets are equal to the current assets, indicating that the company can fulfill its debt obligations. On the other hand, a ratio of 2 suggests that the company has twice as many quick assets as current liabilities, which is a positive sign. However, an excessively high ratio, such as 10, is not considered favorable.

Hence, the acid-test ratio is more conservative in terms of what is classified as a current asset in the formula. This value is over 1.0, indicating that Tesla has decent liquidity and should be able to cover its short-term obligations. 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. Technology companies are another case in point because they have low fixed inventory numbers. In order to compute this company’s acid-test ratio, we simply use the formula provided above.

Example of the Acid-Test Ratio

Modest fluctuations do not automatically spell trouble, but exploring the reasons for changes can help find ways to ward off potential problems. Like the current ratio, the acid-test ratio is an indicator, and a company can manipulate its figures to make it look robust at a given time. Investors who suddenly become keenly interested in a company’s acid-test ratio may be anticipating a downturn in the company’s business, or in the general economy. Acid test ratio excludes prepaid expenses and inventories as these cannot be readily converted into cash. If a company has a higher ratio, the better the company liquidity will be, which results in better overall financial health. But if the ratio is very high, it is also not favorable as the company may have excess cash, but the company is not using it beneficially.

• Looking from the perspective of short-term solvency the company in this case is in a favorable condition.
• The value of inventories a business needs to hold will vary considerably from industry to industry.
• The acid test ratio, also known as the quick ratio, measures a company’s ability to meet its short-term liabilities with its most liquid assets.
• You might be surprised to learn that these terms are actually used in the financial industry as well.

Most companies and investors want a company to have an acid test ratio of one or slightly more than one. This means the company has enough cash, or assets, that quickly convert to cash, to pay all current liabilities. For example, a ratio of 2.5 means the company has $2.5 of liquid assets for each $1 of current liability. However, this also means the company is sitting on cash that it could reinvest in the business. High acid-test ratios are often judged poorly as it means the company is not trying to grow.

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.