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Acid-Test Ratio

What Is the Acid-Test Ratio?

The acid-test ratio, commonly known as the quick ratio, uses a firm’s balance sheet data as an indicator of whether it has sufficient short-term assets to cover its short-term liabilities.

KEY TAKEAWAYS

  • 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.

Understanding the Acid-Test Ratio

In certain situations, analysts prefer to use the acid-test ratio rather than the current ratio (also known as the working capital ratio) because the acid-test method ignores assets such as inventory, which may be difficult to quickly liquidate. The acid test ratio is thus a more conservative metric.

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. 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.

Calculating 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.

The formula is:

\begin{aligned} &\text{Acid Test} = \frac{ \text{Cash} + \text{Marketable Securities} + \text{A/R} }{ \text{Current Liabilities} } \\ &\textbf{where:} \\ &\text{A/R} = \text{Accounts receivable} \\ \end{aligned}​Acid Test=Current LiabilitiesCash+Marketable Securities+A/R​where:A/R=Accounts receivable​

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.

Acid-Test Ratio Example

A company’s acid-test ratio can be calculated using its balance sheet. Below is an abbreviated version of Apple Inc.’s (AAPL) balance sheet as of Jan. 27, 2022, showing the components of the company’s current assets and current liabilities (all figures in millions of dollars):1

 Cash and cash equivalents 37,119
 Short-term marketable securities 26,794
 Accounts receivable 30,213
 Inventories 5,876
 Vendor non-trade receivables 35,040
 Other current assets 18,112
 Total current assets 153,154
Accounts payable74,362
Other current liabilities49,167
Deferred revenue7,876
Commercial paper5,000
Term debt11,169
Total current liabilities147,574

To obtain the company’s liquid current assets, add cash and cash equivalents, short-term marketable securities, accounts receivable, and vendor non-trade receivables. Then divide current liquid current assets by total current liabilities to calculate the acid-test ratio. The calculation would look like the following:

Apple’s ATR = ($37,119 + 26,795 + 30,213 + 35,040) / ($123,529) = 1.05

Not everyone calculates this ratio the same. There is no single, hard-and-fast method for determining a company’s acid-test ratio, but it is important to understand how data providers arrive at their conclusions.

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

Both the current ratio, also known as the working capital ratio, and the acid-test ratio measure a company’s short-term ability to generate enough cash to pay off all debts should they become due at once. However, the acid-test ratio is considered more conservative than the current ratio because its calculation ignores items, such as inventory, which may be difficult to quickly liquidate. Another key difference is that the acid-test ratio includes only assets that can be converted to cash within 90 days or less, while the current ratio includes those that can be converted to cash within one year.

What Does the Acid-Test Ratio Tell You?

The acid-test, or quick ratio, shows if a company has, or can get, enough cash to pay its immediate liabilities, such as short-term debt. For most industries, the acid-test ratio should exceed 1. If it’s less than 1, then companies 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. On the other hand, a very high ratio could indicate that accumulated cash is sitting idle, rather than being reinvested, returned to shareholders, or otherwise put to productive use.

How to Calculate the Acid-Test Ratio?

To calculate the acid-test ratio of a company, divide a company’s current cash, marketable securities, and total accounts receivable by its current liabilities. This information can be found on the company’s balance sheet.

While it’s true the variables in the numerator can be modified, each variation should reflect the most realistic view of the company’s liquid assets. Cash and cash equivalents should be included, as should short-term investments, such as marketable securities. Accounts receivable are sometimes omitted from the calculation because this figure is not appropriate for every industry. The ratio’s denominator should include all current liabilities, which are debts and obligations that are due within one year.The Fundamentals of Corporate Finance and AccountingWhatever your learning style, understanding corporate finance and accounting is easy when you can choose from 183,000 online video courses. With Udemy, you’ll be able to learn accounting terminology and how to prepare financial statements and analyze business transactions. What’s more, each course has new additions published every month and comes with a 30-day money-back guarantee. Learn more about Udemy and sign up today.

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