Acid-Test Ratio: Definition, Formula, and Example
Note that, for the most part, the acid test ratio and quick ratio are used interchangeably. As one would reasonably expect, the value of the acid-test ratio will be a lower figure since fewer assets are included in the numerator. Hence, the acid-test ratio is more conservative in terms of what is classified as a current asset in the formula. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics. Specialties include general financial planning, career development, lending, retirement, tax preparation, and credit. Overall, the applications and interpretations of the acid-test ratio will largely depend on the individual characteristics and sectors of businesses.
- This business’ quick assets are cash and cash equivalents, which has a balance of $100,000, and accounts receivable, which has a balance of $200,000.
- Some analysts might include other balance sheet line items not included in this example, and others might remove the ones used here.
- Lastly, the acid-test ratio can shed light on a company’s operational efficiency, particularly in relation to its management of liquid assets.
If the acid-test ratio is much lower than the current ratio, a company’s current assets are highly dependent on inventory. Recapitalization or restructuring the firm’s capital structure might also come in handy. The goal is to replace short-term debt with shareholders’ equity or long-term debt. While this doesn’t increase liquidity, it helps to reduce the total amount of the firm’s current liabilities, strengthening the acid test ratio on the balance sheet. On the other hand, an excessively high acid test ratio might suggest a company’s overt focus on short-term liquidity at the expense of longer-term investments, including those in CSR and sustainability. Stakeholders invested in a company’s social and environmental impacts might view an exceedingly high quick ratio as a red flag.
Acid Test Ratio Definition: How is Acid Test Ratio Calculated?
The current ratio depicts the holistic near-term financial health, while the acid-test ratio focuses on immediate liquidity. Using them together can provide a more comprehensive view of a company’s financial state. A lower acid-test ratio, on the other hand, suggests that the company might struggle to pay off its current liabilities using solely its quick assets. This could be seen as a warning sign by investors, creditors, and other stakeholders because it indicates the company is less capable of handling a short-term cash crunch. Higher ratios are generally better as they indicate stronger short-term financial health, and the ability of a company to settle its debts without selling inventory.
While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits. While it’s beneficial for companies to strive for an improved acid test ratio, it’s also imperative to keep the broader business goals in perspective. Making short-term improvements at the expense of long-term growth and sustainability may not be the best path forward.
Example of the Acid-Test Ratio
A consistently low acid-test ratio can signal higher financial risk as it indicates that the company may encounter difficulties settling its short-term debt obligations. With fewer inventory write-offs requiring cash to replace parts and less rework labor, businesses have more cash and liquidity. All businesses with inventory must have adequate internal control over the physical custody and recording of inventory.
Interpreting the Acid Test Ratio
Stakeholders should therefore consider this ratio in conjunction with other financial and non-financial indicators when assessing a company’s genuine commitment to social and environmental responsibility. A company’s acid test ratio plays an essential role in strategic business decisions for a couple of significant reasons. Other factors such as the industry sector, market conditions, and individual company circumstances play a role in determining a ‘healthy’ acid test ratio. For instance, if a company operates in a sector where speedy inventory turnover is common, a slightly lower acid test ratio might not be concerning.
In the worst case, the company could conceivably use all of its liquid assets to do so. Therefore, a ratio greater than 1.0 is a positive signal, while a reading below 1.0 can signal trouble ahead. The information we need includes Tesla’s 2020 cash & cash equivalents, receivables, and short-term investments in the numerator; and total current liabilities in the denominator. Either liquidity ratio indicates whether a company — post-liquidation of its current assets — is going to have sufficient cash to pay off its near-term liabilities. The acid-test ratio and current ratio are two frequently used metrics to measure near-term liquidity risk, or a company’s ability to quickly pay off liabilities coming due in the next twelve months.
Handling cash flow problems
Next, we apply the acid-test ratio formula in the same period, which excludes inventory, as mentioned earlier. Therefore, the higher the acid-test ratio, the better the short-term liquidity health of the company. The general rule of thumb for interpreting the acid-test ratio is that the higher the ratio, the less risk attributable levered vs unlevered cash flow in real estate to the company (and vice versa). The current ratio in our example calculation is 3.0x while the acid-test ratio is 1.5x, which is attributable to the inclusion (or exclusion) of inventory in the respective calculations. Since technology is not going anywhere and does more good than harm, adapting is the best course of action.
Acid Test Formula
The tradition is to remove inventories from the current assets total, since inventories are assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly. The rest of the assets on the balance sheet are not quick assets and are therefore excluded from the acid test ratio. A cash flow budget is a more accurate tool to assess the company’s debt commitments. While figures of one or more are considered healthy for quick ratios, they also vary based on sectors. Quick ratios can be an effective tool to calculate a company’s ability to fulfill its short-term liabilities. But it is important to remember that they are useful only within a certain context, for quick analysis, and do not represent the actual situation for debt obligations related to a firm.