What is Acid Test Ratio formula ?
Acid Test Ratio formula also has another name as Quick test ratio. It is a kind of liquidity ratio that usually helps the company/firm to measure its capability to pay nearly all of its current liabilities when quick assets are due. It is also known as the liquidity ratio formula.
In particular short-term periods, quick assets which are also known as the current asset of a company can be converted into cash.
Quick Assets are also considered with few points of a company like company’s cash, company’s cash equivalents, investments which are not long-term or even market securities including current accounts which are receivable.
In next 90 days company’s marketable securities or even short-term investments which include Company’s trading securities and all available sale securities are converted into cash very easily.
Mostly trading of any company’s marketable securities is done in an open market with a particularly known price and with the availability of buyers who are ready to trade. Sometimes it’s very easy to sell any stock of a company to any investor which is also considered as marketable securities.
It happens mostly in an open market. The use of acid to test metals for gold by the early miners in history is a reference of acid test ratio which is also known as Quick ratio. Purity of a metal is checked by conducting Acid test, if sample metal passed then it is considered as gold and if the metal failed the test then it would be corroding from the acid.
Corroding metal would be a base metal which is having a zero or no value. Mostly a company performs good acid test of finance which show the performance of a company that how quickly the company is converting its assets into cash.
Definition of Acid test ratio formula
The calculation of the acid test ratio is done by the division of the total cash and cash equivalents including short-term investments and even the account receivables in current liabilities of the company.
This kind of highly liquid investment is also known as Acid test ratio formula. Any company having a quick ratio of less than 1 indicates that they do not have the required liquid assets to pay its current liabilities, so in this case, a company should be cautious enough. If the current assets of any company are heavily dependent on inventories then that indicates that the quick ratio of that particular company is much lower than its current ratio.
If inventories from the current assets are not included then the conservativeness of a particular quick ratio will be much more than its current ratio.
To generate income most of the company use their long-term assets, selling off these kinds of assets seriously hurts the company and on the other hand also displays to the capable investors that Company’s current operations are not generating enough profits to pay off their current liabilities.
It indicates that a particular company without selling its long-term assets can also pay off companies current liabilities. But a quick ratio higher than 1 shows that the company is owning more quick assets than its current liabilities. An increase in the Company’s liquidity depends on the increase of the quick ratio.
If the quick ratio of a company increases company’s liquidity will also increase. The conversion of a company’s assets into cash completely depends on its necessity.
These kinds of increases in the company’s liquidity show a good sign to the investors and even creditors by securing them that they won’t be at a loss and will be refunded on time. But on the other hand, it always not a good thing to have a very high ratio.
It could also mean that the capital of a company has been accumulated rather than being reinvested or repay it to the investors or use productively.
Therefore those companies who are having a high quick ratio like 7 or 8 mostly generate huge revenues. Companies with quick ratios have drawn criticism from those activist investors who mostly prefer that stakeholders of a company get a particular amount of percentage from the revenue.
Analysis of Acid test ratio formula
To measure the liquidity of a company the acid test ratio is necessary. It actually shows the ability of a company to pay all of its current liabilities with companies quick assets.
To cover total current liabilities, a company should have enough quick assets. For selling off any long-term assets the company should be able to pay its obligations. As according to the studies most company’s uses their long-term assets for generating revenue. In this process, they sell off their capital assets by not affecting the company.
Hence it shows investors or shareholders that the current process in the company is not able to make enough profits to pay-off its current liabilities. To show that there are high number of quick assets in a company than its current liabilities, quick ratios should be higher which makes it more favorable for the company.
To indicate that quick assets should be equal to the current assets a company should be having a quick ratio of 1.
Without selling any of the long-term assets it helps the company to show that it can pay off its current liabilities. The company has quick assets twice its known current liabilities is indicated when the company is having an Acid ratio of 2. In this case it is obvious that an increase in the ratio will also increase the liquidity of a company.
If it’s needed more assets can be converted into cash.
What is considered as acid test ratio ?
Once the quick ratio is calculated, we can determine that:
- If a company is converting its short term assets into cash then the company can meet its short term functions.
- By selling off its inventory a company will be able to meet its functions.
In this case, a company will be purchasing more than needed.
A good quick ratio is 1 or more. Even the quick ratio shows that the available short term marketable assets are enough to cover its short term liabilities. In this case, this number should be higher in which it needs more liquid assets to cover its short term functions and debts. When a company is having less than 1 quick ratio it might indicate that a particular with this number does not have enough liquid asset to cover its current liabilities.
Formula and Calculation of Acid Test Ratio-
By using the formula mentioned below we can calculate the quick ratio:
Acid test ratio formula = (Current Assets LESS Inventory Less Prepaid Expenses)/ Current liabilities.
Total Current Assets includes = Cash, all receivables, deposits, and any vendor or customer receivable in one year. These current assets are mainly can be converted into cash easily. This conversion in cash will help to pay off all the current liabilities.
Current Liability includes = All payables which are due in one year. It also includes all statutory dues, Salary payables, vendor liability, and Government liability.
Accounts receivable, marketable securities, cash and cash equivalents might be included in currents assets.
There is a weakness in the quick ratio that it doesn’t account for time. Also large amount of fund block in inventory will lose current ratio and Acid test ratio formula.
E.g., The customer has not yet paid because of which the discounts included in the early payment scheme as according to the payment term may not be reflected in the balance sheet numbers.
In this, we can see that the accounts receivable balance in the company’s balance sheet can be overstated and the company’s current liabilities may be due now. But they might be not receiving cash from the accounts receivable for 30 to 45 days.
Interpretation of acid-test ratio formula
If a company is having enough quick assets for paying for its current liabilities then that means that the quick ratio of the company is greater than 1.
Quick assets like short term receivables, cash and cash equivalents and etc. can be converted into cash very easily. So, creditors always stay in favour of companies with good quick ratios.
There is a great dependency of an ideal ratio upon the industry when the company is in. Generally, a high quick ratio is not needed by a company that is operating under an industry with a short operating cycle.
There should be a comparison of financial ratios with the industry standards so that we can determine that whether such ratios are normal from what is expected.
Examples of other liquidity ratios-
As it is always advised multiple ratios can be used to understand the current position of a business.
Current and cash ratios can be considered by the small business owner also because both of them are well-known alternatives and they work in conjunction with the quick ratio.
Quick Ratio vs Cash Ratio-
The cash ratio is commonly used to study the short term debt financial health of a firm which compares its current assets with its current liabilities. It is also considered as another liquidity ratio. By excluding both inventory and A/R from the current assets cash ratio is considered as the most conservative of like ratios.
Due to the conservative measures of the stability of the cash ratio, it is sometimes criticized and it is not accounted for in a business that is efficient in collecting A/R by selling through inventory.
Frequently Asked Questions-
Why it is called the “Acid test ratio”?
Ans. It is called the Acid test Ratio because it looks only at the most liquid assets of the company which is available for service of short-term obligations. It is usually can be said that this ratio can convert the liquid asset into cash quickly and easily to pay bills.
What is a good Acid Test ratio”?
A good Acid text ratio in 1:1. This is a standard formula which is used in many other company. Company should keep thier Quick Assets / Quick liability in the same proportion. So that company has good amount of cash in hand. Fund can be used to pay off company liability immediately when it is required.
What happens if the acid test ratio indicates a firm is not liquid?
Ans. Liquidity crisis also arises even at well-developed companies which are also called healthy companies. But these circumstances usually arise which creates difficulty to meet short term obligations like repaying loans and paying salaries and wages or paying to the suppliers. Sometimes these companies even found themselves not able to secure their short term financing to pay off their immediate obligations.
What’s the Difference Between the Acid Test Ratio and Other Liquidity Ratios?
Ans. The quick ratio gives the most immediate picture of the liquidity available. It also looks at the most liquid assets on a company’s balance sheet. It is also considered the most conservative method of liquidity. Less liquid assets are included in the current ratio such as inventories and even other current assets like prepaid expenses.
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