Consider a company with $1 million of current assets, 85% of which is tied up in inventory. Receivables, cash and cash equivalents, prepaid costs, marketable securities, and
inventory are all examples of current assets that might be utilized. The terms account
payable, short-term debt, and accrued obligations are included in the definition of
current liabilities. The acid-test ratio, also known as the quick ratio, considers cash, marketable securities, and accounts receivable because these items can quickly convert into cash. On the other hand, the current ratio also considers inventory and other current assets aside from what the acid-test ratio includes. The acid-test ratio offers an uncompromisingly pragmatic perspective on a company’s liquidity.

The current ratio (also known as the current asset ratio, the current liquidity ratio, or the working capital ratio) is a financial analysis tool used to determine the short-term liquidity of a business. It takes all of your company’s current assets, compares them to your short-term liabilities, and tells you whether you have enough of the former to pay for the latter. Similar to the acid test ratio, companies that have a current ratio of less than one have fewer current assets compared to the liabilities.

Acid-Test Ratio Formula

It’s meant to be used in tandem with other financial ratios and indicators to make a complete and accurate financial assessment. On the other hand, a business with long credit terms or a substantial cash reserve might prioritize other financial ratios over the acid-test ratio. The acid-test ratio can fluctuate dramatically for companies subject to seasonality in their business, such as those in retail or tourism. Consequently, the measure can produce inconsistent results that may not accurately reflect the overall financial health of the company. 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.

The acid-test ratio, also known as the quick ratio, underscores its importance as a critical financial metric used by businesses, investors, and analysts to evaluate a company’s immediate financial health. It is a valuable tool in gauging a firm’s capability to settle its short-term liabilities using its most liquid assets, meaning those that can be promptly converted into cash. Another way to calculate the numerator is to take all current assets and subtract illiquid assets.

In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low quick ratio and yet be very healthy. In its Q fiscal results, Apple Inc. reported total current assets of $135.4 billion, slightly higher than its total current assets at the end of the last fiscal year of $134.8 billion. At the 2022, the company reported $154.0 billion of current liabilities, almost $29 billion greater than current liabilities from the prior period. Tracking the current ratio can be viewed as “worst-case” scenario planning (i.e. liquidation scenario) — albeit, the company’s business model may just require fewer current assets and comparatively more current liabilities.

When to Use the Acid-Test Ratio

Mary Girsch-Bock is the expert on accounting software and payroll software for The Ascent. Natalya Yashina is a CPA, DASM with over 12 years of experience in accounting including public accounting, financial reporting, and accounting policies. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader.

Interpreting the Current 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. The acid test ratio is actually just another name for the quick ratio in financial analysis. It is often helpful in more situations than the current ratio as it ignores all the assets that are not easy to liquidate. If the acid test ratio is much lower than the current ratio, it means that there are more current assets that are not easy to liquidate (e.g., more inventory than cash equivalents). If Company A’s acid test ratio or quick ratio is 1.1, it means that Company A depends more heavily on inventory than any other current asset. This finding is not an indication of imminent danger, but a closer look at the type of company that shows these numbers can reveal more information.

Quick ratio (acid test ratio): What you need to know

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. However, because it includes inventory, this ratio can sometimes be skewed, especially for industries where inventory turnover is slow. Inventory refers to the raw materials, work-in-progress goods and completely finished goods that are considered to be the portion of a business’s assets that are ready or will be ready for sale. While inventory is indeed a part of a company’s short-term assets, it often can’t be as quickly as converted into cash as other current assets.

Overall, the applications and interpretations of the acid-test ratio will largely depend on the individual characteristics and sectors of businesses. This flexibility in assessment is necessary to accommodate the unique financial circumstances what is the difference in share classes presented by each company. Interpretation of the acid-test ratio can also be a limitation as it largely depends upon the industry. What might be considered a good ratio in one industry could be seen as a poor ratio in another.

The cash asset ratio, or cash ratio, also is similar to the current ratio, but it only compares a company’s marketable securities and cash to its current liabilities. The acid-test ratio is used to indicate a company’s ability to pay off its current liabilities without relying on the sale of inventory or on obtaining additional financing. Inventory is not included in calculating the ratio, as it is not ordinarily an asset that can be easily and quickly converted into cash. Compared to the current ratio – a liquidity or debt ratio which does include inventory value in the calculation – the acid-test ratio is considered a more conservative estimation of a company’s financial health. Some of the current assets used include accounts receivables, cash and cash equivalents, prepaid expenses, marketable securities and inventory. Current liabilities used include accounts payable, short-term debt and accrued liabilities.

Example of Current Ratio and Acid Test Ratio

The current ratio is a less conservative measure than the acid-test ratio, because it includes inventory. When the inventory owned by a business takes a long time to liquidate, the current ratio can be misleading, because it assumes that the inventory can be readily converted into cash. The acid-test ratio makes no such assumption, since it excludes inventory from the calculation.

Suppose a company has the following balance sheet financial data in Year 1, which we’ll use as our assumptions for our model. For example, a company with a low ratio might not be at too much of a risk if it has non-core fixed assets on standby that could be sold relatively quickly. More detailed analysis of all major payables and receivables in line with market sentiments and adjusting input data accordingly shall give more sensible outcomes which shall give actionable insights. As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy. Baremetrics monitors subscription revenue for businesses that bring in revenue through subscription-based services.

The interpretation and implications of a company’s acid-test ratio can vary depending on the company’s industry, its business cycle stage, and trends in its historical acid-test ratios. Thus, the ratio should not be examined in isolation but looked at in context with other financial indicators and factors. At the end of the forecast period, Year 4, our company’s ratio remains relatively unchanged at 0.5x, which is problematic, as concerns regarding short-term liquidity remain. Perhaps it is taking on too much debt or its cash balance is being depleted—either of which could be a solvency issue if it worsens. The trend for Horn & Co. is positive, which could indicate better collections, faster inventory turnover, or that the company has been able to pay down debt.

Using our ABC Company example (with inventory of say $29m), the acid-test ratio would be 100,000,000 minus 29,000,000 divided by 67,000,000 to equal 1.06 or 106%. This figure means that, for every dollar of current liabilities, the company has $1.06 of easily convertible assets. Again, what would be considered an acceptable acid-test ratio will vary from industry to industry. Among methods that are used to measure liquidity include the acid test ratio and current ratio methods. The acid-test ratio, commonly known as the quick ratio, uses data from a firm’s balance sheet to indicate whether it has the means to cover its short-term liabilities. Generally, a ratio of 1.0 or more indicates a company can pay its short-term obligations, while a ratio of less than 1.0 indicates it might struggle to pay them.

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. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Lea is passionate about impactful businesses, good writing, and the stories founders have to tell.

Deja una respuesta

Tu dirección de correo electrónico no será publicada. Los campos obligatorios están marcados con *