Meaning of Acid Test Ratio
- Popularly known as quick ratio, the acid test ratio is a financial measure of a company’s ability to pay off its current liabilities.
- Current liabilities refer to the debt that is to be repaid within a period of one year such as credit card balance etc.
- It is an indicator of the company’s short term financial health.
- An acid test ratio lesser than one usually implies that the company does not currently have sufficient current assets to cover its short-term debts/ liabilities.
- A very high ratio indicates that the cash has accumulated and is idle without being reinvested into productive activities.
- It is important to note that the company disregards current assets that are hard to liquidate quickly while calculating the ratio.
Calculation of the Ratio
It is calculated as – Acid-test ratio = (cash + accounts receivables + short-term investments)/current liabilities Cash and cash equivalents should be included. Short-term investments, such as marketable securities, must be included too. Accounts receivable is generally included, but not in the case of every industry. Other elements, such as advances to suppliers, prepayments, and deferred tax assets, that appear as assets on a balance sheet must be subtracted if they cannot cover liabilities in the short term. The denominator should include all current liabilities, which are debts and obligations that are due within one year.
Limitations of the Ratio
- Inaccurate picture of the company’s financial health means the company has accounts receivable that take longer than usual to collect.
- It also provides an inaccurate picture of the current liabilities that are due but no immediate payment is there to that effect.
- For business models that are inherently dependent on inventory having a low acid test ratio does not necessarily signify poor financial health.
Difference Between Current Ratio and Acid Test Ratio
- Current ratio or working capital ratio measures the company's short-term ability to generate enough cash to pay off all debts if they happen to be due all at once.
- The acid test ratio on the other hand, is a more conservative measure.
- Acid-test ratio includes only assets that can be converted to cash within 90 days or less, while the current ratio includes those that can be converted to cash within one year.
