What is the acid-test ratio and why does it matter?
When it comes to assessing your financial health, there are a number of tools that you can use. One of the most helpful is the acid test ratio. Also known as the quick ratio, this is a measurement that takes data from your balance sheets to determine whether or not your organisation can cover its short-term liabilities.
Acid-test ratio – a way of measuring if an organisation has sufficient short-term assets to cover immediate liabilities.
This is similar to the current ratio — also known as the working capital ratio — except that it is generally considered more conservative. This is because the acid-test ratio does not include items like inventory which may be difficult to liquidate quickly and does not consider any assets that cannot be converted into cash within 90 days.
Why is the acid-test ratio important?
The acid-test ratio lets you know if your organisation has, or will have, enough cash to pay your immediate liabilities, including things like short-term debt, accounts payable, and accrued liabilities. The test also demonstrates a company's ability to pay off current debts without relying on inventory and shows management how quickly assets can be converted into cash.
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How is the acid-test ratio calculated?
When calculating your acid-test ratio, you want to gain a realistic view of your organisation's liquid assets. Let's take a look at the equation you'll use to calculate the ratio.
Acid-test formula:
Acid-test ratio = Cash + Marketable Securities + accounts receivable/Current liabilities
With that in mind, the numerator of your equation should include cash and cash equivalents. Generally speaking, you'll want to incorporate your accounts receivable, though this may vary depending on your industry. As an example, the construction industry typically has a longer turnaround time than other industries. Including AR in a construction company's acid-test ratio would make its financial position seem more secure than it is in reality.
Another method is to simply take all of your organisation's current assets and subtract those that are not liquid. Elements such as supplier advances, prepayments, and deferred tax assets should also be subtracted from your total.
On the denominator side of the equation, you'll want to include all liabilities, debts, and obligations that your company owes in the next year.
What is a good acid-test ratio?
Now that we know how to calculate the acid-test ratio, what is a good number to land on? For most companies, the ratio should exceed 1.0. Anything less than that indicates that your company does not have enough liquid assets to cover its obligations.
There are some exceptions to this. Particular business models, especially those in retail, are heavily dependent on inventory. Because of this, a retail organisation may have a very low acid-test ratio, but not be in any danger.
While a higher number is typically good, it could also indicate that available cash is not being used constructively. In other words, the cash is sitting idle when it could be invested or put toward growth opportunities.
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What is an example of an acid-test ratio?
With all of this in mind, let's take a look at a hypothetical organization's acid-test. Assume that ABC Company has:
- Cash and cash equivalents of £50,000,000
- Short-term marketable securities of £30,000,000
- Other current assets £20,000,000
This would result in £100,000,000 in total current assets. Now we'll turn our attention to the company's liabilities. Let's assume:
- £40,000,000 in accounts payable
- £50,000,000 in other current liabilities
- £7,000,000 in deferred revenue
Using these numbers, the company has £97,000,000 in current liabilities.
To calculate the acid-test ratio, we'll divide £100,000,000/£97,000,000. This results in a ratio of 1.03, indicating that the organisation has the assets needed to cover its short-term liabilities.
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