The acid test ratio is a critical financial metric that investors and traders should understand. It is important because it gives a tough measure of whether a company has enough cash to pay its bills without having to sell inventory. Beginners in investment and new investors should find this article helpful in making informed investment decisions.
What do you mean by acid test ratio?
The acid-test ratio is a ratio that determines if a company’s short-term assets are sufficient to cover its current liabilities or not. In other words, the acid-test ratio indicates how effectively a corporation can meet its short-term (current) financial obligations. Further, it will be explained how to compute the ratio step by step and examine the implications.
Understanding the Acid Test ratio
In some cases, analysts prefer to use the acid-test ratio over the current ratio (also known as the working capital ratio) since the acid-test technique ignores assets like inventory, which might be difficult to dispose of quickly. Thus, the acid-test ratio is a more cautious measure.
Ratio ≥ 1: This shows that a business possesses enough current assets to settle short-term debts. Usually, it is a good indication of financial well-being.
Ratio < 1: This implies that an enterprise may find it difficult to meet its near-future payments, so investors and creditors should take note.
Importance of Acid Test Ratio
Liquidity Assessment: The acid test ratio identifies a company’s most liquid asset to assess liquidity. It enables stakeholders to know how well-placed the company is in meeting immediate financial obligations.
Credit Rating: Lenders use this ratio to ascertain a company’s creditworthiness. A high ratio shows that the entity is more likely to pay back its debts, making it less risky for lenders.
Risk Management: Investors looking for less risky businesses should look for those with a high acid test ratio. This means that the firm can continue operating and paying its bills when sales fall.
Calculations required for Acid-Test Ratio
Formula –Acid test ratio = cash equivalents + marketable securities + account receivables
Current Liabilities
Here,
Cash equivalents: Cash equivalents are the most liquid current assets on a company’s balance sheet, and they include savings accounts and term deposits with maturities of less than three months.
Marketable securities: Liquid financial products that can be easily exchanged for cash.
Accounts receivable: money owing to the company due to providing customers goods and/or services.
Current liabilities: Debts or commitments that are due within a year.
A formula can be alternatively rendered as:
Acid Test Ratio = Current Assets – Inventories
Current Liabilities
Were,
Current assets: assets that can be reasonably converted into cash within one year.
Inventories: the value of materials and goods held by a corporation for the purpose of selling them to customers.
Example
Consider a company, XYZ Corporation, with the following financial details:
- Current Assets: US$120,000
- Inventories: US$50,000
- Current Liabilities: US$30,000
Determine the acid test ratio for XYZ Corporation.
Step-by-Step Calculation
- Identify current assets:
- Cash: US$40,000
- Accounts Receivable: US$40,000
- Marketable Securities: US$30,000
- Total Current Assets = Cash + Accounts Receivable + Marketable Securities = US$ 50,000 + US$ 40,000 + US$ 30,000 = US$ 120,000
- Identify Inventories:
- Inventories: US$50,000
- Identify current liabilities:
- Accounts payable: US$30,000
- Short-term Loans: US$20,000
- Other Current Liabilities: US$10,000
- Total Current Liabilities = Accounts Payable + Short-term Loans + Other Current Liabilities = US$ 30,000 + US$ 20,000 + US$ 10,000 = US$ 60,000
- Calculate the acid test ratio:
Acid test ratio = cash equivalents + marketable securities + account receivables
Current Liabilities
- Substitute the values:
Acid test ratio = 120,000 – 50,000 / 60,000
= 70,000 / 60,000
= 1.17
Frequently Asked Questions
What are the limitations of the acid test ratio?
The acid test ratio is a useful tool, but it also has drawbacks:
- Exclusion of Inventories: In certain sectors, goods can be sold off quickly because they are highly liquid. If such inventories are left out, the company’s liquidity may be distorted.
- Static snapshot: At a specific date, this ratio measures liquidity only; it does not make changes in the environment over time.
What is the difference between the acid test ratio and the current ratio?
Differences are mentioned below:
- The current ratio calculates the proportion of current assets to current liabilities, whereas the acid test ratio determines the proportion of the most liquid current assets to current liabilities.
- The purpose of the current ratio is useful for determining the firm’s ability to meet its present obligations. In contrast, the acid test ratio is useful in determining a firm’s ability to meet any urgent requirement.
- Current assets are cash, cash equivalents, prepaid expenses, inventory, etc., while acid test assets include only the most liquid current asset, which can be cash and cash equivalents.
What components are included in the acid test ratio?
The components involved are as follows:
- Cash and cash equivalents: This includes actual cash in hand and short-term investments that can be easily converted into cash.
- Marketable Securities. These are liquid financial instruments easily converted into cash at a rational price.
- Accounts Receivable. Customers owe the company money for goods or services supplied but not yet paid for.
What is the difference between the acid test ratio and the current ratio?
Industries with quick inventory turnover and easy cash conversion may find little use for acid test ratios. These include the following:
Retail: large-volume businesses like retail, where goods are sold quickly, have high inventory turnovers that can almost be equated to cash or accounts receivable, hence the need to exclude inventory;
Grocery Stores: Grocery stores usually have fast-moving stocks, implying their stocks can readily be turned into money;
Restaurants and Food Services: Such companies also experience high rates of food and beverage sales, which means that measuring their liquidity using only acid tests is not very accurate.
Pharmaceuticals There are times when pharmaceutical firms may record high medicine moving speeds if there is constant demand, although this is not always the case since it varies from time to time.
These businesses should use current ratios instead of quick ratios because inventories can easily be converted into cash.
What are some common benchmarks for the acid test ratio?
For most sectors, the acid-test ratio should be more than 1.0. If it is less than 1.0, the company does not have enough liquid assets to cover its existing liabilities and should be handled with prudence. If the acid-test ratio is significantly lower than the current ratio, it indicates that a company’s current assets rely heavily on inventories. On the other side, an extremely high percentage may imply that accumulated cash is lying idle rather than being reinvested, given to shareholders, or otherwise put to productive use.
