What is the Acid Test Ratio?

Q:

What is the acid test ratio?

A:

The acid test ratio is also know as the quick ratio. It helps present a picture of a company’s short-term liquidity. Essentially, it determines how well a  company can promptly meet its short-term liabilities with its most liquid assets. You will notice that the formula to calculate the ratio leaves out the least-liquid current assets such as prepaid expenses and inventory. These assets are not guaranteed to quickly convert into cash so they are not considered.

Acid Test Ratio Formula

The acid test ratio is calculated as follows:

(Cash & Cash Equivalents + Short-Term Investments + Net Current Receivables) ÷ Total Current Liabilities

Let’s clarify a couple of the assets found in the formula above.

  • Cash and cash equivalents are pretty self-explanatory. These are assets that are currently cash or highly liquid assets that can easily be converted to cash within three months.
  • Short-term investments must be able to be sold within one year or within the firms operating cycle.
  • Net current receivables are either accounts receivable or interest receivable, which do not include any allowances.

Keep in mind that the following formula is also used to calculate the acid test ratio. It simply takes that current assets and subtracts out the least liquid current assets.

(Current Assets – Inventories – Prepaid Expenses) ÷ Current Liabilities

How to Interpret the Acid Test Ratio?

Generally, an asset test ratio over 1 means that a company has ample ability to meet short-term liabilities. However, the norm depends on the industry that the company operates in. As with many other ratios such as the current ratio, a firm’s acid test ratio should be compared against other competitors in the industry.

Acid Test vs Current Ratio

The acid test ratio and the current ratio are both used to judge a firm’s liquidity. The current ratio is calculated using current assets ÷ current liabilities. It does not exclude the current assets of inventory and prepaid expenses like when we calculate the acid test ratio. The acid test ratio is much better at determining if a company can pay its short-term liabilities because it only uses the most liquid current assets in is calculation.