How to Calculate Acid-Test Ratio: Overview, Formula, and Example

Put simply, a company with an acid-test ratio of 1 or more has enough liquid assets to cover its current liabilities. If the company had to pay off all its current liabilities immediately, it could do so without resorting to selling its non-liquid assets. Quick assets for this purpose include cash, marketable securities, and good debtors only.

Acid-Test Ratio vs Current Ratio

Moreover, the acid-test ratio may provide a hint towards the future performance of a firm. A consistently high acid-test ratio indicates that the business maintains a sufficient level of liquid assets, enabling it to withstand sudden economic downturns or unexpected expenses. It suggests a certain level of operational efficiency and effective asset management, potentially leading to stable returns and growth in the future. Once you’ve calculated a company’s acid-test ratio, you can use the resulting figure to evaluate its short-term liquidity and financial health.

• It is also known as the Quick Ratio and is calculated by dividing the total current assets excluding inventory by the total current liabilities.
• On the other hand, industries like retail and manufacturing typically have lower acid-test ratios.
• The current ratio gives a general overview of a company’s liquidity by indicating whether it has enough resources to cover its liabilities for the next 12 months.
• Therefore, in this scenario, we would probably conclude that we are relatively healthy.

Accounts Payable Essentials: From Invoice Processing to Payment

For purposes of calculation, acid-test ratios only include securities that can be made liquid immediately or within the next year or so. The trick is to consider what a sensible figure is for the industry under review. A good discipline is to find an industry average and then compare the current and acid test ratios against for the business concerned against that average. Widely thought of as a more conservative metric, unlike the working capital ratio, it does not include assets that cannot be quickly liquidated, such as inventory. It excludes inventory from the calculation because inventory is not always easily converted to cash. By using a combination of financial ratios and modeling techniques, analysts can gain a more comprehensive understanding of a company’s bottom line and make more informed financial decisions.

The alternative approach involves what is acid test ratio deducting a company’s inventories from its current assets. After that, it requires the division of the residual amount by the current liabilities. Liquidity ratios help stakeholders understand the contrast between a company’s performance and obligations. More specifically, these ratios help reveal whether a company’s current assets can cover its current liabilities.

The Acid-Test Ratio Formula

Therefore, in this scenario, we would probably conclude that we are relatively healthy. If we wanted to further improve our ratio, however, we could take measures such as collecting our AR more proactively, or taking longer to pay our suppliers. A ratio above 1.0 means that the company can theoretically pay off all its current liabilities even without needing to sell off its inventory. I say “theoretically” because, in practice, the acid-test ratio doesn’t consider the exact timing that the payments are owed, so it will always be just a high-level approximation. Generally speaking, anything above 1.0 is considered a “good” ratio, while anything below 1.0 would start to raise concerns.

What You Need to Calculate the Acid-Test Ratio

A low acid-test ratio may raise concerns about a company’s liquidity and its capacity to meet immediate financial obligations. This can lead to a company exploring strategies to improve its liquidity position, such as optimizing cash management practices and enhancing collection processes for accounts receivable. The acid test ratio is a vital metric for businesses to assess their liquidity and ability to pay off immediate liabilities. It’s a critical indicator for small companies to evaluate their financial health and stability. On top of that, considering the immediate liquidity of an asset may require judgment from stakeholders.

An essential method to improve your acid test ratio is to keep the company’s liabilities under control. In the acid test ratio, current liabilities are in the denominator that if kept low will put your business in a better position. This can be done through paying off creditor quickly and reducing the repayment terms on your loans. On the other hand, a high or increasing acid test ratio indicates a company has faster inventory turnover and cash conversion cycles. This ratio happens when a company is experiencing top-line growth, quickly converting receivables into cash, and are easily able to cover its financial obligations. Acid-test ratios less than 1 may mean the company does not currently have sufficient current assets to cover its current liabilities.

That being said, it’s only possible to interpret the ratio by considering the trend for that company, how it compares to other companies in its industry, and the broader business context for the company. Below is a break down of subject weightings in the FMVA® financial analyst program. As you can see there is a heavy focus on financial modeling, finance, Excel, business valuation, budgeting/forecasting, PowerPoint presentations, accounting and business strategy.

How Do You Calculate the Acid-Test Ratio?

A similar dynamic applies when we consider a company’s commitment to sustainability. Implementing sustainable practices often involves significant capital investment. This could be expenses related to upgrading facilities, changing supply chains, developing new products, or improving waste management practices. Strong financial health, as indicated by a high acid-test ratio, might allow a company to make these investments without jeopardizing its short-term financial stability.

For example, Walmart, Target, and Costco are big retailers who can negotiate favorable supplier terms that do not require them to pay their vendors immediately or based on norms in the industry. Even within the retail industry, the level of inventory holdings can vary based on the retailer size. A figure of 0.26 means that ABC does not have sufficient assets to liquidate, if its creditors come calling. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.