Acid-test ratio definition
/What is the Acid-Test Ratio?
The acid-test ratio compares a company’s most short-term assets to its short-term liabilities. The intent of this ratio is to evaluate whether a business has sufficient cash to pay for its immediate obligations. If not, there is a significant risk of default. It is commonly used by creditors and lenders to evaluate their customers and borrowers, respectively. Investors may also use it to discern whether a business has so much excess cash that it can afford to issue a dividend to them.
How to Calculate the Acid-Test Ratio
To calculate an organization’s acid test ratio, add together its cash, marketable securities and accounts receivable, and then divide by the total amount of current liabilities. All of this information is stated in separate line items on a firm’s balance sheet. The current liabilities figure is stated as a subtotal on the balance sheet. The formula for the acid-test ratio is as follows:
(Cash + Marketable securities + Accounts receivable) ÷ Current liabilities = Acid test ratio
The intent behind using this ratio is to examine the liquidity of a business, so be sure to exclude from the cash, marketable securities, and accounts receivable figures any assets that cannot be accessed. For example, if cash or marketable securities are restricted from use, then do not include them in the calculation. Similarly, if you are aware of any accounts receivable that are not expected to be collected on time, then consider excluding them from the calculation. Also, do not include inventory in the calculation, since it can take a long time (if ever) to convert inventory into cash. Only then will the ratio yield a true interpretation of company liquidity.
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How to Interpret the Acid-Test Ratio
When the acid-test ratio reveals a ratio of 1:1 or worse, it indicates that a business could be at significant risk of not being able to pay its liabilities as they come due. However, if a business has a line of credit that it can drawn down to pay off any obligations as they come due, then even a low ratio may not be a valid indicator of payment problems. This is also the case when there is a wealthy investor that is willing to invest more cash in the business, as needed.
A better proportion for the ratio is 2:1, which generally indicates enough liquidity to settle all obligations. However, even with such a favorable ratio, it is possible that timing differences will exist, such as a large liability that is due for payment within the next few days, while the offsetting assets may not be liquidated for another few weeks.
Another issue is when an extremely high ratio exists, such as anything over 5:1. In this case, a business is sitting on an excessive amount of liquid assets that it cannot use. In this case, it might make more sense to pay the excess assets to investors in the form of a dividend or a stock buyback.
When to Use the Acid-Test Ratio
The ratio is most useful in those situations in which there are some assets that have uncertain liquidity, such as inventory. These items may not be convertible into cash for some time, and so should not be compared to current liabilities. Consequently, the ratio is commonly used to evaluate businesses in industries that use large amounts of inventory, such as the retail and manufacturing sectors. It is of less use in services businesses, such as Internet companies, that tend to hold large cash balances.
Example of the Acid-Test Ratio
A business has $50,000 of cash, $80,000 of marketable securities, and $270,000 of accounts receivable, which are offset by $100,000 of current liabilities. The calculation of its acid-test ratio is:
($50,000 Cash + $80,000 Securities + $270,000 Receivables) ÷ $100,000 Current liabilities = 4:1
Though the 4:1 result makes it appear that the firm can easily pay off its current liabilities, this may not actually be the case. The key issue is how long it will take for the organization to liquidate its receivables.
Advantages of the Acid-Test Ratio
A major advantage of using the acid-test ratio is that the information needed to construct it is located on an organization’s balance sheet. This document is part of the financial statements, and as such should be readily available - especially for publicly-held businesses.
Disadvantages of the Acid-Test Ratio
Though generally reliable, the ratio can yield incorrect indications when a company has an unused line of credit. In this situation, it may have little or no cash on hand, and yet can draw upon the cash in the line of credit to pay its bills. The same situation applies when a business is closely-held by a wealthy shareholder; there is a good chance that this party will contribute sufficient funds to the business to keep it in operation, even if the ratio indicates that it is not especially liquid.
The ratio can be a poor indicator when current liabilities cover an extended period of time. By definition, current liabilities include any liabilities due within the next year. A liability due at the far end of this period still appears in the denominator, even though there is no immediate need to pay it.
Current Ratio vs. 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. Therefore, the acid-test ratio can be considered a more reasonable tool for evaluating an organization’s liquidity than the current ratio.
Terms Similar to The Acid-Test Ratio
The acid-test ratio is also known as the quick ratio and acid ratio.