Acid-Test Ratio

What Is the Acid-Test Ratio?

The acid-test ratio, or the quick ratio, is a type of liquidity ratio that measures a company's ability to pay its short-term liabilities with assets that can be readily converted into cash.

Financial ratio analysis is regarded as one of the oldest and the simplest means of testing the viability of a business entity, even if such tests cannot provide a complete picture of a business's health.

Liquidity management plays a crucial role in understanding a company's performance.

In simple terms, the ratio measures a company's ability to cover its current liabilities using assets that can be easily converted into cash.

Such assets are classified as "quick" due to their ability to convert quickly into cash. Generally, any asset converted into cash within 90 days can be classified as a quick asset. Some examples of quick assets are:

• Cash
• Marketable securities
• Accounts receivable

Understanding the acid-test ratio analysis

It is used to show the company's ability to meet its current liabilities without additional financing or the sale of inventory.

As opposed to other current ratios that consider inventory value, the ratio takes a more conservative approach to estimating the company's financial position.

A company with a higher ratio is said to have a better liquidity position and good financial health. On the other hand, an extremely high quick ratio is considered unfavorable as it indicates:

• Inefficient use of excess cash for the company's growth purposes.
• High accounts receivables and the possibility of collection issues.

Companies with a ratio of less than one should be dealt with cautiously. This is because such companies tend to have insufficient liquid assets to meet their current obligations.

An acid-test ratio is also known as a quick ratio, and it can be measured using the given formula:

Acid-Test Ratio = [Cash & Equivalents + Marketable Securities + Accounts Receivable]/ Current Liabilities

OR

= [Current Assets - Inventory - Prepaid Expenses] / Current liabilities

Example: 

Consider these two hypothetical companies

Calculations:

• Company A: (Current Assets - Inventories) / (Total Liabilities - Non-Current Liabilities)
  = (15000 - 5000) / (10000 - 2000)
  = 10000 / 8000
  Quick Ratio = 1.25
• Company B: (Cash + Marketable Securities + Accounts Receivable) / Accounts Payable
  = (10000 + 20000 + 25000) / 10000
  = 55000 / 10000
  Quick Ratio = 5.5

Analysis:

• Company A: A ratio of 1.25 indicates that the company has sufficient quick assets to pay its current obligations up to 1.25 times its current value. Essentially, this means that the company is maintaining enough cash, and the rest is being utilized for growing the business.
• Company B: A ratio of 5.5 indicates that the company has enough quick assets to pay its current liabilities up to 5.5 times. This means that the company has more cash than needed. Instead of keeping the money idle, it should be utilized for growing their business.

There isn't any optimal number that's standard across companies. To derive the true impact of a company's liquidity position, one must consider the following factors:

• Nature of the company's business
• The industry with which the company can be associated
• Marketplaces where the company runs its operations
• Overall financial stability of the company

Importance of acid-test ratio

Ratio analysis is regarded as one of the best tools to conduct a financial statement analysis.

Different ratios can be used to identify various aspects of a company. For example, the ratio balance, a liquidity ratio, helps understand the company's liquidity position.

The quick ratio can be for different uses based on the group's interests. The three main groups that benefit from ratio analysis are management, stockholders & investors, and creditors or lenders.

An acid test or the quick ratio is generally used to understand the ability of a company to raise money to meet current obligations quickly. However, the interpretation of results can be different for the three groups:

• Management: They use it to measure the company's performance. This can help command in the following ways:
  • First, assess the company's ability to honor short-term commitments.
  • Identify the accounts having irregularities in payments.
• Stockholders and Investors: They use it to measure the company's performance and to understand the potential risk they would face from a decision taken by the management team. 
  • Example: The company decides not to use excess cash for growth. Instead, they keep it as a reserve. This indicates the possibility of an investment with low risk and low returns.
• Creditors and Lenders: This information helps lenders understand the firm's ability to adapt to changing conditions in the market environment. They can further be used to analyze how the firm has honored repayments in the past. 

Why is inventory excluded from the ratio calculation? 

Unlike the current ratio, the quick ratio takes a more conservative approach to view the company's liquidity position. This ratio measures the company's ability to meet its current liabilities with its short-term or quick assets.

Inventory cannot be included in the calculation as it is not generally considered a liquid asset. In addition, quick assets exclude stock because it usually takes more time for a company to sell its inventory and convert it into cash.

Many companies have been known to apply steep discounts to sell their inventory in a short span of 90 days or less. This causes uncertainty in the value of stocks and makes it difficult to evaluate when determining the liquidity position.

acid-test ratio Formula

To calculate the ratio, it is vital to identify and interpret each component in the balance sheet's current liabilities and current assets section. The corresponding values can then be plugged into the formula.

The acid-test ratio is a more stringent measure of a company's short-term liquidity than the current ratio.

The critical difference between calculating the Current Ratio and the Quick Ratio is that the quick ratio does not include inventory and deferred expenses as a part of the current assets.

Generally, a ratio of 1 or more indicates that the company has good financial health and can very well meet its current liabilities without selling its long-term assets.

However, one must further investigate a company's financial health better.

Formula

The ratio, as mentioned above, is a metric used to determine a firm's ability to quench its debts in the short term by utilizing its most liquid assets.

The ratio is also known as a quick ratio, and it can be measured using the given formula:

Acid-Test Ratio = [Cash & Equivalents + Marketable Securities + Accounts Receivable]/ Current Liabilities

OR

= [Current Assets - Inventory - Prepaid Expenses] / Current liabilities

Quick Assets Formula

The quick assets of a company can be determined by using the given formula:

Quick Assets = Current Assets - Inventories - Prepaid Expenses.

OR

Quick Assets = Cash + Accounts Receivable + Marketable Securities

How to Calculate the acid-test ratio

A company's quick ratio is calculated by identifying relevant assets and liabilities in the company's accounts. Financial managers must calculate these ratios and present their judgments to the board.

Investors and lenders of the company can also use available company information to calculate its quick ratio. The whole process can be broadly classified under three steps:

Step 1: The first step is to identify cash and cash equivalents, marketable securities, and accounts receivable from the company's balance sheet. These items constitute the quick assets of the company.

Step 2: Locate the current liabilities from the company's balance sheet.

Step 3: Add the quick assets and substitute the values in the formula to obtain a rapid ratio. In other words, add all the quick assets and divide by the value of the current liabilities.

Example 1

Computation:

Acid-Test ratio = [Current Assets - Inventory - Prepaid Expenses] / Current liabilities

• Interpretation: Currently, the Ratio reveals that the company has a weak liquidity position with a quick ratio of 0.95. This shows that it cannot pay off its short-term obligations with cash. Whereas, in the previous quarter, i.e., Q4 2021, the company had just enough money to pay off its current liabilities.

Example 2

Computation:

Acid-Test ratio = [Current Assets - Inventory - Prepaid Expenses] / Current liabilities

• Interpretation: Currently, the Ratio reveals the company's very strong liquidity position, with the quick Ratio being 6.34. This shows it can pay off its short-term obligations with cash. 
  It is also observed that there is a significant improvement in its quick Ratio from the previous quarter. It now can pay 6.34 times the value of current liabilities as compared to 5.69 times in the last quarter, i.e., Q4 2021.

What is a good Acid-test ratio?

A ratio that is equal to or greater than one is generally considered to be good. A percentage greater than one or equal to 1 shows that the company has enough liquid assets to meet its current liabilities.

On the other hand, if a business's Ratio turns out to be less than 1, it shows that the company doesn't have sufficient liquid assets to meet its short-term liabilities.

The company may face difficulties raising cash to pay its creditors in case of an emergency.

However, an extremely high quick ratio might be a bad sign, as it can be interpreted as poor management from the company's end. This is because it shows that the company, despite having excess cash, is not investing in expanding its business.

A standard ratio doesn't exist because it is subjective to various factors that affect a business. Some of the factors that help determine an optimal quick ratio for the company are:

• Nature of Industry
• Markets in which the business operates
• Age of the business
• Creditworthiness

Example: A startup may face difficulty operating under a low quick ratio compared to a well-established business with a strong supplier relationship and creditworthiness. 

Interpretation: In the above example, a well-established business can easily attain additional financing at a low interest rate, or the company can negotiate credit extension terms with its suppliers in an emergency. These options help a well-established company to run its operations smoothly despite having a lower ratio.

Limitations Of Acid-Test Ratio

The Ratio is merely a mathematical value that provides no context on the assets and liabilities themselves. This causes various limitations while being used as a critical decision-making tool. Some of the limitations of this tool are:

• Comparison across industries: A major drawback of the Ratio is that it cannot be used to compare various industries at once. The metric can only be used to carry out comparisons of similar companies. 
• Timeframe of payments: It doesn't consider the time frame of costs. The collection period of accounts receivable can have a negative impact if delayed.

• Example: Accounts receivable of the company may include bad debts that will never be recovered in the future or may contain receivables that will be recovered after more than a year. 
• Interpretation: This negatively impacts the company's liquidity position, but the Ratio may omit all these factors and portray a positive result. In this case, there is a high probability that a decision based on the Ratio will be wrong.
• Inventory: Excluding inventory may help provide a more conservative approach to determining the company's liquidity position. The method may backfire while analyzing industries with higher inventory turnover ratios.
  • Example: A supermarket that purchases millions of dollars of inventory using credit or cash. Here, the firm's current liability is increased due to purchasing inventory on credit.
  • Interpretation: In such cases, the firm's current liability would be significantly higher than the quick assets, resulting in a low quick ratio. Since the Ratio excludes inventories, a clear picture of the firm's liquidity cannot be assessed.

Hidden factors that don't affect the Ratio

• Inventory turnover: Inventory is excluded from quick assets due to difficulties converting it to cash. However, a high inventory turnover ratio would mean more significant sales. 
  This makes inventory conversion into cash quicker, meaning that a company would be better positioned to pay off short-term debtors. Unfortunately, the quick Ratio ignores this entirely.
• Accounts receivable: The collection of accounts in a shorter period positively impacts the firm's ability to pay off debtors. This will also reduce the chances of bad debts.
• Liabilities: Paying off penalties sooner will help enhance the company's financial health. This also allows the company maintains a good proportion of quick assets to current liabilities.

Acid-Test Ratio vs. Current Ratio

Both ratios are used to calculate the company's liquidity position. Also, there isn't any typical value that can be set as a standard for comparison. Instead, the key difference lies in the components used to calculate these ratios.

The current ratio takes inventory into the calculation, including items that cannot be sold quickly or those with uncertain liquidation values. As a result, this becomes a significant drawback when determining the company's ability to pay off current obligations.

The quick ratio is more conservative as it excludes inventory from the current assets. On the other hand, the current ratio includes all the items forming part of the company's existing assets.

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Annuity Due
• Arbitrage Pricing Theory
• Assessing Debt Capacity
• Asset Base
• Asset Coverage Ratio