What Is Acid Test Ratio – Formula, Calculation, Importance and Interpretation
The acid test ratio, also known as the quick ratio, is a quantitative measure that determines an organisation’s ability to pay its current liabilities by liquidating its current assets. However, not all current assets are liquid. Two kinds of current assets – prepaid expenses and inventory – cannot be immediately liquidated. Hence, we use ‘quick assets’ to determine this ratio.
What Does the Acid Test Mean?
The acid test means that a company has to prove that it cannot pay its liabilities using its current assets. These assets are classified as ‘quick’ based on their ability to be liquidated. The faster you can liquidate them, the more readily you can pay off your liabilities.
Thus, the acid test ratio measures how liquid an organisation is regarding current assets and liabilities. Let us see how it can be calculated.
Also Read: What Are Capital Assets: Types, Taxation & Exemptions
Formula of Acid Test Ratio
The acid test ratio formula is:
Acid test ratio = quick assets / current liabilities
Here, quick assets = current assets – prepaid expenses – inventory
A 1:1 ratio is considered ideal. Applying this formula, we can arrive at a ratio between the quick assets and the current liabilities. Let us understand the calculation better with an example.
How to Calculate Acid Test Ratio?
Let us take the example of Company X to know how the acid test ratio is calculated.
Company X had current assets worth Rs.6,00,000. Of this, Rs.3,40,000 were its inventories, and Rs. 60,000 amounted to the prepaid expenses. The current liabilities of Company X were measured at Rs.2,00,000.
Company X’s acid test ratio will be calculated as follows:
Quick assets = current assets – prepaid expenses – inventories
= 6,00,000 – 3,40,000 – 60,000
= 2,00,000
Acid test ratio = quick assets / current liabilities
= 2,00,000 / 2,00,000
= 1:1
Being 1:1, the acid test ratio is ideal. Let us see what this implies.
What is an Acid Test Ratio Interpretation of Results?
The acid test ratio measures how many of a company’s current liabilities can be covered by its liquid assets. The ideal acid test ratio is 1:1. This implies that just enough quick assets can be liquidated to cover the company’s short-term liabilities.
A ratio higher than 1:1 signifies that the company has plenty of quick assets that it can encash in case of emergencies. This improves the firm’s liquidity, which is a good sign for its growth and sustenance. It is also taken as a positive thing by investors and creditors, who are assured that their payments will not be delayed. However, too high a ratio implies improper management of assets. Too much cash means that not all growth prospects and reinvestment opportunities have been taken.
A ratio lower than the ideal 1:1 ratio means that the firm does not have enough quick assets to cover its short-term liabilities, implying significant levels of illiquidity. The cash is either blocked in long-term investments or less liquid assets, and the company relies heavily on inventory to meet its upcoming debt obligations. This must be treated cautiously, as illiquidity can harm all company stakeholders, including shareholders and creditors.
Why is Acid Test Ratio Important for Businesses?
The following points highlight the importance of the acid test ratio:
1. Quick way of calculating the liquidity of the business
The acid test ratio does not involve any complex calculations. It only requires information regarding the current liabilities and assets, which can be seamlessly obtained from the organisation’s financial statements. The resulting ratio is easy to analyse, and the stakeholders can quickly analyse the company’s position.
2. Gives an accurate measure of a firm’s ability to meet its obligation
Compared to the current ratio, the acid test ratio is deemed more fit to measure the firm’s ability to meet its upcoming financial obligations. This is because it only includes those current assets that can be readily converted into cash, such as marketable securities and accounts receivable. This metric does not rely on inventories, which makes it more accurate since inventories may take longer to convert into cash.
3. Helps measure an organisation’s solvency
In case of a financial emergency or any other unexpected circumstances, the firm must be solvent enough to pay its creditors, investors, and other stakeholders. The acid test ratio helps in determining how solvent the firm is. If the ratio is not ideal, the management can take measures to improve the firm’s solvency to sustain financially straining situations.
4. Helps investors and creditors to assess an organisation
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.
Difference between Acid Test Ratio and Current Ratio
The acid test and current ratio measure a firm’s liquidity. However, there is a slight difference between the two. As mentioned above, the acid test ratio only considers the quick assets, which are the current assets that can be converted into cash quickly. This includes accounts payable, cash, and cash equivalents. On the other hand, the current ratio considers all the current assets, including inventories and prepaid expenses.
This creates a fundamental difference between the two. The current ratio includes inventories, which can be time-consuming to liquidate. Even though the current ratio is a good measure of short-term liquidity, the acid test ratio only considers the quick assets, giving a more accurate measure of a firm’s ability to meet its obligations in the future.
Mathematically, the difference can be seen in the way they are calculated. You can find out the current ratio using the following formula:
Current ratio = current assets / current liabilities
The ideal current ratio is 2:1, unlike the ideal acid test ratio, which is 1:1.
Let us take an example. Company ABC has the following current assets in its balance sheet: Accounts receivable of Rs. 50,000, Cash of Rs. 2,00,000, marketable securities of Rs. 45,000, prepaid expenses of Rs. 5,000, and inventory of Rs. 1,00,000. The current liabilities of Company ABC amounts to Rs. 2,00,000.
The current ratio will be:
Current assets = accounts receivable + cash + marketable securities + prepaid expenses + inventory
= 50,000 + 2,00,000 + 45,000 + 5,000 + 1,00,000
= 4,00,000
Current ratio = current assets / current liabilities
= 4,00,000 / 2,00,000
= 2:1
Now, the acid test ratio will be:
Quick assets = accounts receivable + cash + marketable securities
= 50,000 + 2,00,000 + 45,000
= 2,95,000
Acid test ratio = quick assets / current liabilities
= 2,95,000 / 2,00,000
= 1.48:1
As you can see, the two ratios differ and can be analysed differently.
Also Read: What Is Free Cash Flow? How To Calculate It And Why Is It Important For Investors?
What are Acid Test Ratio Levers to Improve Liquidity?
The main levers of the acid test ratio to improve the liquidity of a firm include:
- Having a quick turnover of the inventory.
- Faster accounts receivable, which means quicker recovery of the credit extended.
- Better management of accounts payable, which allows a better idea of upcoming liabilities.
- Improved worker efficiency, focusing on timely collection of payments and better cash management.
- Increased investment in marketable securities that allows the funds to compound while remaining highly liquid.
Final Word
The acid test ratio is useful for assessing an organisation’s liquidity. It excludes those current assets – inventories and prepaid expenses – that cannot be quickly converted into cash. It is thus an accurate way to analyse whether a firm will be able to meet its current liabilities or not. This metric is useful for many stakeholders of the firm.
FAQs
Ans. Acid test ratio measures an organisation’s ability to pay its current liabilities by liquidating its quick assets. It is a measure of a firm’s liquidity.
Ans. Acid test ratio = quick assets / current liabilities
Here, quick assets = current assets – prepaid expenses – inventory
Ans. The ideal acid test ratio is 1:1. It shows that the liquid assets are just enough to meet the short-term liabilities of the organisation.
Ans. Acid test ratio excludes prepaid expenses and inventories as these cannot be readily converted into cash.
Ans. The acid test ratio is also known as the quick ratio. It is different from the current ratio.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
