Acid Test Ratio

Acid Test Ratio

Acid Test Ratio

The acid test ratio compares a company’s most liquid assets to its most liquid liabilities. The goal of this ratio is to determine if a company has enough cash to meet its immediate obligations. Otherwise, there is a high probability of default.

It is often used by creditors and lenders to assess the creditworthiness of their clients and borrowers, respectively. Investors may also use it to determine whether a company has enough cash on hand to pay out a dividend.

Acid Test Ratio Formula

The following is the formula for calculating the acid test ratio:

Acid Test Ratio = (Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivables) / Total Current Liabilities

A company’s balance sheet will include the following items:

  • Cash and cash equivalents, such as savings accounts, term deposits with maturities of less than three months, and T-bills, are the most liquid current assets on a company’s balance sheet.
  • Marketable securities are liquid financial products that can be changed into cash quickly.
  • Accounts receivable are the funds owing to the firm as a result of supplying products and/or services to consumers.
  • Current liabilities are debts or commitments that must be paid within a year.

Another popular formula generates the acid test ratio by first subtracting inventory from total current assets and then dividing the amount by total current liabilities. Inventory is disregarded from this calculation since it is not seen as a quick cash convertible. It is expressed mathematically as,

Acid test ratio = (Total current asset – inventory) / Total current liabilities

Acid Test Ratio Calculation

The following formula can be used to calculate the acid-test ratio:

Acid Test Ratio = (Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivables) / Total Current Liabilities

Step 1: Add Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivables

Step 2: Subtract the sum from step 1 from the current liabilities.

Acid Test Ratio Example

ABC Limited’s current assets and current liabilities are as follows:

ParticularsAmount
Cash$5000
Account Receivable$20000
Marketable Securities$5000
Inventory$4000
Account payable$15000

Acid Test Ratio = (Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivables) / Total Current Liabilities

Acid Test Ratio = (5000 + 5000 + 20000) / (15000 + 5000)

Acid Test Ratio = 30000/ 15000

Acid Test Ratio = 2

The company’s acid-test ratio is 2, which means that the company’s liquid assets are worth twice as much as its current liabilities.

What is a Good Acid Test Ratio?

For example, if a company’s acid-test ratio is 2, it means that the company’s liquid assets are worth twice as much as its current liabilities. So, if current liabilities are $100,000 and the acid-test ratio is 2, liquid assets are $200,000. This ratio indicates good financial health.

Acid Test Ratio Interpretation

When the acid-test ratio shows a ratio of 1:1 or worse, it suggests that a company may be in serious danger of being unable to pay its liabilities when they become due.

However, if a company has a line of credit that it may use to pay off commitments as they come due, even a low percentage may not be a reliable sign of payment issues. This is also true when a wealthy investor is prepared to put additional funds in the firm as needed.

A better ratio percentage is 2:1, which often implies sufficient cash to satisfy all obligations. Even with such a favorable ratio, temporal discrepancies are possible, such as a big debt due for payment within the next few days while the offsetting assets are not liquidated for another few weeks.

Another concern arises when the ratio is exceptionally high, such as anything greater than 5:1. In this instance, a company has an overwhelming amount of liquid assets that it cannot use. In this instance, it may make more sense to distribute excess assets to shareholders in the form of a dividend or a stock repurchase.

Advantages of Acid Test Ratio

  • The acid test ratio excludes inventory from the computation, which is not usually deemed liquid, resulting in a more accurate view of the company’s liquidity condition.
  • Because inventory is omitted from current assets, bank overdrafts and cash credit are removed from current liabilities because they are typically backed by inventory, making the ratio more significant in determining the company’s liquidity status.
  • Inventory valuation can be difficult, and it may not always be at marketable value. As a result, the acid test ratio is not affected since inventory valuation is unnecessary.
  • Inventory may be quite seasonal and change in an amount over the course of a year. If taken into account, it has the potential to deflate or inflate the liquidity situation. The acid test ratio eliminates this issue by excluding inventories from the calculation.
  • In a dying business, which typically has a significant level of inventory, this ratio will offer the company more consistent repayment capabilities than the current ratio, which includes inventory.
  • If the current ratio is applied, a company’s short-term financial health may be overestimated due to its huge inventory base. This scenario may be resolved by applying the acid test ratio, which limits firms from obtaining more loans, the servicing of which may be more difficult than suggested by the existing ratio.

Disadvantages of Acid Test Ratio

  • Using this ratio alone may not be adequate to determine the company’s liquidity condition. Effective analysis may necessitate a comparison with peers and industry standards.
  • This ratio excludes inventory from the computation, which may be unsuitable for organizations whose inventory can be easily appraised at a marketable price. It should be included rather than excluded when calculating the company’s liquidity status.
  • This ratio may not be a reliable indication for all company models for demonstrating short-term solvency since enterprises with more inventory, such as supermarkets, may remove inventory to arrive at a liquidity position that is not basically realistic.
  • The acid test ratio disregards the volume and timing of cash flows, which would be a crucial determinant of the company’s capacity to pay liabilities as they fall due.
  • The ratio assumes that accounts receivable are liquid and quickly convertible to cash, which is not always the case.

Acid Test Ratio Vs Current Ratio

Because it incorporates inventories, the current ratio is less conservative than the acid-test ratio. When a company’s inventory takes a long time to sell, the current ratio might be deceptive since it believes the inventory can be easily turned into cash. The acid-test ratio makes no such assumption since it does not include inventories in the computation.

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