What is an Acid Test Ratio?
Definition: An acid-test ratio is defined as a financial measure of a firm’s potential to repay its immediate liabilities, which means the loans/ debt need to be paid in a year, such as accounts payable and credit card bills. The figure will be greater than the current ratio because it overlooks assets such as inventory. Acid Test Ratio is also known as Quick Ratio.
The acid-test ratio is a liquidity ratio that utilizes a company’s balance sheet information to know if it has adequate short-term assets to pay its short-term liabilities. The acid test specifies whether a business can repay such types of loans instantly via cash or current assets. It computes a company’s short-term financial health.
A normal liquid ratio is supposed to be 1:1. If an organization has a ratio of less than 1, it would not be able to repay its current liabilities immediately completely. A quick ratio of 2.0 means that the company has $2.00 in liquid assets accessible to pay each $1.00 of immediate liabilities.
To completely understand an organization’s current liquid assets, short-term marketable securities, current receivables, vendor non-trade receivables, and cash equivalents are added and then divide the sum of these assets by total current liabilities to compute the acid test ratio.
Understanding Acid Test Ratios
The acid-test ratio helps specify a company’s potential to pay off its loans without depending on the inventory sale or gaining extra funding. Inventory is not used in computing the ratio since it is not normally an asset that can be effortlessly and quickly transformed into cash.
Compared to the quick ratio – a liquidity or debt ratio comprising inventory cost in the calculation – the acid-test ratio is referred to as a more conventional approximation of a company’s financial health.
Preferably, companies should have an acid test ratio of 1.0 or more. That would indicate that the company has enough current assets to pay off its short-term debt or invoices. The acid-test ratio can be affected by other factors like the time it takes for a company to accumulate its accounts receivables, the timing of asset acquisitions, and how bad-debt allowances are handled.
Many tech companies may have high acid-test ratios, which are not negative but instead specifies that they have a great amount of cash on hand.
Acid Test Ratios Calculation
The acid test ratio is calculated by taking the total cash and equivalents, accounts receivables, and marketable investments and dividing it by current liabilities.
Add all the available liquid assets – cash that the company has in hand and divide it by the company’s short-term loan. The items mentioned above can all be found on a company’s balance sheet. Cash and cash equivalents are the most liquid current assets on a company’s balance sheet, such as savings accounts, a term accumulation with a maturity of lesser than three months.
Marketable securities are liquid financial means that can be voluntarily converted into cash. Account receivables are the money payable to the company from providing customers with goods or services. Current liabilities are loans or obligations yet to pay in one year.
The alternate Formula of Acid Test Ratio is-
Current assets are assets that can be rationally transformed into cash within one year. Inventories are the cost of materials and goods owned by a company to market them to the customers.
Improving Acid-Test Ratios
Businesses with higher acid-test ratios are deemed more financially steady than those with a lower quick ratio. An acid test ratio greater than one is thought to be healthy and is significant for external stakeholders like lenders, creditors, capitalists, and investors.
The ways to improve a company’s acid-test ratio are:
1. Repat Liabilities as Fast as Possible
A significant way to improve a company’s acid test ratio is to keep the liabilities/loans under control. In the acid test ratio, current liabilities are in the denominator. If the denominator is lower than the numerator (assets), it is better. It would put the business firm in a better position. This can be done by repaying the creditor speedily and dipping the reimbursement terms on the loans.
2. Upsurge Inventory Sales & Turnover
Increasing the company’s sales will advance the inventory turnover, which can upsurge a company’s cash on hand. Increased sales and inventory turnover will lead to more cash available to repay its short-term obligations. For inventory to be transformed into cash, it must be vigorously traded. Increased sales that yield the inventory will advance the acid ratio test.
3. Decrease Invoice Collection Time
Reducing the period for the gathering of the accounts receivable will have an absolute and positive effect on the company’s acid ratio test.
It would help a business’ inward cash flow and decrease the odds of combatting long-term debtors, bad debts, and sticky debtors.
Advantages of Acid Test Ratios
- The acid test ratio eliminates the inventory from the calculation, which may not always be considered liquid, thereby giving a more appropriate image of the company’s liquidity position.
- As inventory is eliminated from current assets, bank overdraft and cash credit are separated from current liabilities since they are generally secured by inventory, thus making the ratio more profound in deriving the company’s liquidity position.
- Computation of inventory can be complicated, and it may not always be at a vendible cost. So, the acid test ratio does not depend on it, as there is no requirement to estimate the inventory.
Disadvantages of Acid Test Ratios
- The acid-test ratio alone is not enough to know about the liquidity position of the company. Other liquidity ratios such as the current ratio or cash flow ratio are commonly used in combination with the acid-test ratio to offer a more comprehensive and accurate approximation of a company’s liquidity condition.
- The ratio ignores inventory from the calculation because inventory is not usually included in a liquid asset. Although, some businesses can briefly sell their inventory at a reasonable market cost. In such cases, the company’s inventory does succeed as an asset that can willingly be transformed into cash.
On the concluding note, it is clear that Acid-Test Ratio or quick ratio can be understood as a liquidity ratio that is used for measuring the efficiency of short-term assets of a company in covering its current liabilities.
You may also understand it as a measure of how capable your company is in fulfilling the short-term financial obligations.
Now, after understanding the whole concept, what will be your definition of acid test ratio? Share with us in the comment section below.