The acid test ratio, which is also called the quick ratio, is a financial measure of how quickly a company can pay off its current debts. Current obligations are debts that have to be paid back within a year. For example, a credit card balance is a current obligation.
The ratio shows how well the business is doing financially right now.
If a company’s acid test ratio is less than one, it usually means that its current assets are not enough to pay off its short-term debts and liabilities. A very high ratio suggests that money has been saved up and is just sitting there, not being put to good use.
It’s important to know that when figuring out the ratio, the company doesn’t count current assets that are hard to sell quickly.
How to find the acid test ratio
The acid-test ratio is calculated by dividing current liabilities by (cash + accounts receivable + short-term investments). Cash and assets that can be used as cash must be included. There must also be marketable securities and other assets that can be used quickly. Accounts receivable are usually covered, but not in every business. If assets on a balance sheet, like loans to suppliers, prepayments, and deferred tax assets, can’t pay off liabilities in the near future, they must be taken off. The denominator should include all current liabilities, which are debts and commitments due within a year.
The limits of the Ratio
If the company’s financial data is inaccurate, it will have accounts receivable that require longer than usual to be collected.
Also, it gives a false picture of the current liabilities that are due but won’t be paid for a while.
A low acid test ratio doesn’t always mean that a business strategy that depends on stock is in bad financial shape.
The acid test ratio is different from the current ratio
The current ratio, also called the working capital ratio, shows how quickly a company can make enough cash to pay off all its debts if they all come due at once.
On the other hand, the acid test ratio is a more cautious measurement.
While the current ratio includes assets that can be converted to cash within a year, the acid-test ratio only includes assets that can be done so within 90 days or less.
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