The Acid-Test Ratio, sometimes called the Quick Ratio, is a liquidity ratio that assesses a company’s capacity to settle its immediate liabilities using its most liquid assets.
Usage
It measures how much of a company’s present assets are liquid, or easily convertible into cash to settle its immediate liabilities. The Acid-Evaluation Ratio does not include inventory in the calculation of current assets, is thought to be a more rigorous test of a company’s financial stability than the Current Ratio.
History
Investors, creditors, and analysts frequently utilize the Acid-Test Ratio concept, which has been around for several decades, to evaluate a company’s financial health.
By dividing a company’s liquid assets by its current liabilities, the ratio is determined. Cash, marketable securities, and accounts receivable are examples of liquid assets.
Calculation
The Acid-Test Ratio of a corporation would be 2 ($100,000 / $50,000) if it had $100,000 in liquid assets and $50,000 in current liabilities, for instance. A healthy ratio is one that is 1 or greater and shows that the company has enough liquid assets to satisfy its immediate liabilities. A ratio below 1 can be a sign that the business will have trouble making its short-term debt payments.
Calculator
Acid-Test Ratio Calculator
What is a good Acid-Ratio?
A ratio of 1 or greater is regarded as positive, meaning the business has enough liquid assets to cover its immediate liabilities. To fully understand a company’s financial situation, it is crucial to take the Acid-Test Ratio into account with other financial measures and variables.
What can a company do if acid-ratio is not met?
Limiting current liabilities: The business can try to work out longer payment terms with its suppliers or look into getting a quick loan to pay off current liabilities.
Selling non e-essential assets: The company can recover unpaid accounts receivable, or raise more money through equity or debt offers to increase its liquid assets.
Improving inventory control: The company can raise its liquid assets and, as a result, improve its Acid-Test Ratio by reducing the amount of inventory it has on hand.
Enhancing cash flow management: The business can put stronger cash management strategies into place, such as cutting back on pointless spending, strengthening terms of payment with suppliers, and boosting customer collections.
What does a bad Acid Ratio signal?
It can indicate to potential lenders and investors that the business is having financial problems, which might lead to a decline in investment and an increase in borrowing costs. To decide the best course of action to increase its financial stability and Acid-Test Ratio, the company may need to consult a financial expert or accountant.
Drawbacks of measurement
Only the most liquid assets, such as cash and marketable securities, are taken into account by the Acid-Test Ratio; it ignores other assets that might be quickly convertible to cash, such as accounts receivable or inventories. This could result in a company’s ability to fulfill its immediate responsibilities being underestimated.
Differences between industries: Because different businesses have varying liquidity needs, not all organizations should use the Acid-Test Ratio as a measurement. Even while a retail company may be financially stable, it may have a considerably faster inventory turnover than a manufacturing company, which could lead to a lower Acid-Test Ratio.
Time-sensitive: The Acid-Test Ratio represents a snapshot of a company’s financial situation at a certain point in time and does not take future trends or projections into account. As a result, the company’s financial situation might not be accurately represented.
Ignoring solvency into account: The Acid-Test Ratio simply assesses a company’s capacity to pay its short-term debt; it does not take into account its capacity to pay back long-term debt or the general profitability of the company.
Is the Acid-Ratio useful?
It should be seen in the context of other elements including profitability, debt levels, and market movements as one of several criteria used to assess a company’s financial health. The Acid-Test is not the only indicator of a company’s financial health and should not be relied upon in isolation to assess a company’s financial standing.