Acid Test/Quick Ratio

Definition Of Acid Test/Quick Ratio-

The second liquidity ratio we'll look at is the Acid-Test Ratio. This ratio is more stringent than the current ratio since it only uses more liquid assets to cover current liabilities. To meet current liabilities, it utilizes cash and cash equivalents, short-term investments, and short-term (current) receivables.

In other words, the Acid Test ratio is a ratio that analyzes a company's liquidity and ability to meet its short-term obligations /commitments . This ratio is an adapted version of the current ratio that attempts to overcome the current ratio's shortcomings. The Quick ratio is also known as the Acid test ratio. The pros and cons of the acid test ratio / quick ratio are discussed in this article.


Formula:

Acid Test/Quick Ratio


Where do we find the information for this ratio?

Cash & Cash Equivalents: Balance Sheet

Short-Term Investments: Balance Sheet

Current Receivables: Balance Sheet

Current Liabilities: Balance Sheet


View:

  • If an entity's acid test ratio is more than 1.0, it is regarded financially secure and capable of satisfying its short term liabilities. Because it eliminates inventory, which is thought to take longer to convert into cash, this ratio is a more conservative estimate than the commonly used current ratio.

  • A low or decreasing trend in the acid test ratio, as a rule of thumb, suggests that a company is experiencing weak top-line growth and is having difficulty managing working capital due to a shorter creditor term or a longer receivable period.

  • On the other hand, a high or rising trend in the acid test ratio indicates that the company is experiencing significant top-line growth, is fast converting receivables into cash, and is confident in its financial obligation coverage.


What's the Difference Between Current and Acid-Test Ratios?

The current ratio, also known as the working capital ratio, and the acid-test ratio both assess a company's capacity to earn enough cash in the short term to pay off all of its debts if they all came due at the same time. The acid-test ratio, on the other hand, is considered more conservative than the current ratio because it excludes items like inventory, which might be difficult to unload rapidly. Another significant distinction is that the acid-test ratio only considers assets that can be converted to cash in 90 days or fewer, but the current ratio considers assets that can be converted to cash in one year.


Pros and Cons of Acid Test Ratio:

Pros-

  • The acid test ratio eliminates inventory from the equation, which isn't necessarily considered liquid, and so provides a more accurate view of the company's liquidity situation.

  • Because inventory is not included in current assets, bank overdrafts and cash credit are not included in current liabilities because they are frequently secured by inventory, making the ratio more significant in determining the company's liquidity status.

  • Inventory valuation is difficult, and it is not always at marketable value. As a result, the acid test ratio is unaffected because inventory valuation is not required.

  • Inventory can be quite seasonal and fluctuate in quantity over the course of a year. If taken into account, it has the potential to deflate or inflate the liquidity situation. The acid test ratio solves this difficulty by excluding inventory from the equation.

  • If the current ratio is employed, a company's short-term financial strength may be overestimated due to its huge inventory base. This problem can be resolved with the acid test ratio, which will prohibit enterprises from obtaining new loans, the servicing of which may not be as simple as the existing ratio suggests.

Cons-

  • The use of this ratio alone may not be sufficient to assess the company's liquidity situation. Effective analysis may necessitate a comparison examination with peers and industry standards.

  • This ratio ignores inventory, which may not be ideal for businesses whose inventory can be easily appraised at a marketable price. It should be included rather than excluded when calculating the company's liquidity status.

  • This ratio may not be a reliable indicator for all company models for demonstrating short-term solvency because it may not be essentially correct to exclude inventory to get at a liquidity position in organizations with typically higher inventory, such as supermarkets.

  • The acid test ratio ignores the amount and timing of cash flows, which are important factors in establishing a company's capacity to pay its debts when they are due.

Example:

Q1)-

Current Assets- 134,836,000

Current Liabilities - 125,481,000

Cash & Cash Equivalents- 34,940,000

Account Receivables - 51,506,000

Short-Term Investments - 27,699,000


Solution:

Acid-Test Ratio = (Cash & Cash Equivalents + Short-Term Investments + Current Receivables) / Current Liabilities


=34,940,000 + 51,506,000 + 27,699,000/125,481,000

=0.91

Acid Test/Quick Ratio Example