Acid Test Ratio Meaning, Formula, Calculation, Interpretation

The acid test ratio is an important indicator of a company's financial health. A ratio lower than one indicates that the company's liquidity position is mismanaged. This may cause a company to rely on debt. However, more debt means more interest cost, and a weak acid test ratio does not add up to a desirable combination. 

Did You Know? A company's inventory is not included in the calculation of liquid assets for the acid test ratio. The reason is that inventory is not intended to be held for sale unless they are converted into finished foods.

What Is the Acid Test Ratio?

Let us first start with knowing what is acid test ratio in financial terms. An acid test ratio, in financial terms, is a type of liquidity ratio that measures a company's ability to meet its current financial obligations. For a healthy financial position of a company, the acid test ratio is 1:1. If a company has an acid test ratio of less than 1, it does not have enough liquid cash to meet its current financial obligation. A company with poor liquidity must try to reduce its current liabilities and increase its liquid assets to strengthen its financial position.

However, a poor acid test ratio is not a bad sign in every case. For example - retain stores have huge funds being invested in the inventory and, thus, usually have a low acid test ratio, but it does not mean they are in danger. Quick ratios may vary from industry to industry and business to business. 

For most of the industry, an Acid ratio above 1 is a good sign. However, it also indicates that the company is left with idle cash and is not returning to shareholders or investing in expansion plans, but the cash is left unproductive without earning any significant return on them.

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The Formula of Acid Test Ratio

The acid test ratio can be calculated as liquid assets divided by current liabilities. Another way to calculate is to substitute inventories and prepaid expenses from current assets to calculator liquid assets and divide them by the current liabilities. 

Other approaches could include calculating the liquid assets directly, and it could include cash and cash equivalents, marketable securities, and account receivables, and then dividing them with current liabilities. These could be summarised from the following formulas -

Acid Test Ratio = Cash + Cash Equivalents Marketable Securities Accounts Receivables + Current Liabilities

Or,

Liquid Assets + Current Liabilities

Or,

Current Assets - Inventory / Current Liabilities

Where

• Cash and Cash Equivalents are that liquid cash or other current assets which are expected to be convertible into cash or bank balance within a period of 3 months. This may include fixed deposits, term deposits, balances in saving and current accounts, etc.
• Prepaid Expenses are expenses that are paid in advance but are related to the next accounting year, like prepaid insurance
• Marketable Securities are financial securities and instruments that have a ready market and could be converted into liquid cash or bank balance within no time like Shares and securities of listed publicly traded companies.
• Accounts Receivables are the amounts of money that are owned by the customers of the company to whom goods or services were supplied on credit
• Current Liabilities are short-term debts of the company which is due for payment within one year
• Inventory of a company means raw material, work in progress, and finished goods that are not ready for sale or if ready are not sold
• Current Assets are the resources of the company from which economic benefits are expected to be derived within the current accounting period.

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Acid Test Ratio Example 

1. Following is an extract of the balance sheet for an illustrative Company, ABC Ltd., for the purpose of this example -

• Acid Test Ratio = (₹10000+₹12500+₹12500) / (₹15000+₹14500+₹5000)

= ₹35000 / ₹34500

= 1.01

  Interpretation of The Acid Test Ratio

• If a company has an acid test ratio of less than 1, it indicates that the company has insufficient liquid assets to pay off its current financial obligations. For example - a company with less than 1 acid test ratio will not be in a position to pay off the creditors, banks, or lenders, which are expected to be due within the current accounting year. This could be interpreted as the company’s inability to pay off its current commitments leading to a loss of goodwill and reputation. The company could badly embarrass itself on its financial commitments.
• A weak acid test ratio could also indicate a decrease in the company’s growth performance and a poor cash management system. This may require a check on the operations of the company.
• A high acid test ratio indicates that the company is financially sound and its operations are showing good signs of growth. This may create confidence in the management and a sound working environment.

Difference Between Acid Test Ratio and Current Ratio

Both current and acid test or quick ratio measures the company’s ability to pay off its current short-term debts and financial obligations as and when they become due for payment. However, the acid test ratio considers liquid assets for measuring the company’s financial soundness, which is considered more conservative than the current ratio. The current ratio, on the other hand, considers the company's current assets as a whole to measure its ability to off the current liabilities. 

It is worth noting that current assets include liquid assets and inventory and prepaid expenses; both of these are not really going to liquidate any time soon. It is quite prudent to consider liquid assets only for measuring the company's liquidity position.

Also Read: Differences between Financial Accounting and Management Accounting

Drawbacks of Acid Test Ratio

There are a lot of benefits of using the acid test ratio as a financial analytical tool. There are certain drawbacks as well. Here are a few of them -

• The acid test ratio is not the sole indicator of a company's liquidity position. Rather, a current ratio can also be used as a tool for the liquidity position of the company.
• While the acid test ratio indicates the liquidity position of the company. Companies usually rely on cash flow statements to understand how liquid their business is and what are the various sources of cash flows and where their cash is being burned. Thus, The acid test ratio may offer insight, but the cash flow statement offers more scope for decision-making and analysis.

Conclusion:

The acid test or quick ratio is a strong indicator of a company's financial health. A company with a strong acid test ratio is considered liquid and has the ability to pay off its current debt and financial obligations. 

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. 

However, on the contrary, a company with a very high acid test ratio may say 5 or 7 has too many idle liquid assets which could otherwise be invested into productive usage. 

It is also worth noting that different businesses run on different business models, like a retail store may have too much working capital invested in inventory and thus will have a low quick ratio. This does not indicate that they are financially not liquid to pay off the current debts.
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