Acid Test Ratio

What is the Acid Test Ratio?

Definition: The acid test ratio, sometimes called the quick ratio, is a liquidity ratio that measures a company’s ability to pay off its current debts with only quick assets. Quick assets, sometimes called cash equivalents, are current assets that can be quickly and easily converted into cash in the current period. These assets include cash, short-term investments, and current receivables.

What Does Acid Test Ratio Mean?

What is the definition of acid test ratio? In a sense, the quick ratio is a quiz to see how liquid a company is by comparing the current liabilities with the quick assets. If a company has enough cash and cash equivalents to pay off its current debt, creditors shouldn’t be worried about being paid. The company can easily meet all of its current obligations without having to sell any of its long-term assets. Investors will also be happy because companies that maintain high levels of liquidity are typically stable and grow more profitable in the future.

How to Calculate the Acid Test Ratio?

The numerator of the acid test ratio can be defined in various ways, but the main consideration should be gaining a realistic view of the company’s liquid assets. Cash and cash equivalents should definitely be included, as should short-term investments, such as marketable securities.

Accounts receivable are generally included, but this is not appropriate for every industry. In the construction industry, for example, accounts receivable may take much more time to recover than is standard practice in other industries, so including it could make a firm’s financial position seem much more secure than it is in reality.

Another way to calculate the numerator is to take all current assets and subtract illiquid assets. Most importantly, inventory should be subtracted, keeping in mind that this will negatively skew the picture for retail businesses because of the amount of inventory they carry. Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments, and deferred tax assets.

The ratio’s denominator should include all current liabilities, which are debts and obligations that are due within one year. It is important to note that time is not factored into the acid-test ratio. If a company’s accounts payable are nearly due but its receivables won’t come in for months, that company could be on much shakier ground than its ratio would indicate. The opposite can also be true.

The acid test ratio formula is calculated by dividing quick assets by current liabilities:

Acid test ratio = Quick assets : Current liabilities
Acid test ratio = (Cash + Marketable Securities + Accounts Receivable) : Current Liabilities

The following items can all be found on a company’s balance sheet:

  • Cash and cash equivalents are the most liquid current assets on a company’s balance sheet, such as savings accounts, a term deposit with a maturity of fewer than 3 months, and T-bills.
  • Marketable securities are liquid financial instruments that can be readily converted into cash.
  • Accounts receivables are the money owed to the company from providing customers with goods and/or services.
  • Current liabilities are debts or obligations due within one year.

Let’s take a look at an example.

Example

Sally’s Shoe Store is considering opening another location, but Sally needs to obtain bank financing in order to afford the new location. The bank asks to see her financial statements to evaluate her liquidity.

Sally’s balance sheet shows $1,000 of cash and $2,000 of accounts receivable. Sally doesn’t have marketable investments or securities. The balance sheet also reports current liabilities of $2,000 making her quick ratio equate to 1.5 ($1,000 + $2,000 / $2,000).

This means that Sally has even quick assets to cover current debt obligations 1.5 times over. In other words, Sally can pay off all of her current debt and still have cash in the bank. This is exactly what the bank wants to see. Sally will probably get her loan after the bank evaluates a few other financial ratios.

What Does the Acid Test Ratio Tell You?

Companies with an acid-test ratio of less than 1 do not have enough liquid assets to pay their current liabilities and should be treated with caution. If the acid test ratio is much lower than the current ratio, it means that a company’s current assets are highly dependent on inventory.

This is not a bad sign in all cases, however, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid test ratios without necessarily being in danger.

For the three months ending October 31, 2018, Wal-Mart Stores Inc.’s acid test ratio was 0.81, while Target Corp.’s was 0.83. In such cases, other metrics should be considered, such as inventory turnover. The acceptable range for an acid test ratio will vary among different industries, and you’ll find that comparisons are most meaningful when analyzing peer companies in the same industry as each other.

For most industries, the acid test ratio should exceed 1. On the other hand, a very high ratio is not always good. It could indicate that cash has accumulated and is idle, rather than being reinvested, returned to shareholders or otherwise put to productive use.

Some tech companies generate massive cash flows and accordingly have acid test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits.

Summary

  • The acid test, or quick ratio, compares a company’s most short-term assets to its most short-term liabilities to see if a company has enough cash to pay its immediate liabilities, such as short-term debt.
  • The acid test ratio disregards current assets that are difficult to liquidate quickly such as inventory.
  • The acid test ratio may not give a reliable picture of a firm’s financial condition if the company has accounts receivable that take longer than usual to collect or current liabilities that are due but have no immediate payment needed.
  • In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills.
  • Too low a ratio can suggest a company is cash-strapped, but in some cases, it just means a company is dependent on inventory, like retailers.
  • Too high a ratio could mean a company is sitting on cash, but in some cases, that’s just industry-specific, like with some tech companies.

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