Short-term liquidity is extremely important for an organisation. If you are planning to invest in a company or trade in its shares over the next few weeks or months, you need to assess this aspect along with other technical and fundamental metrics. The acid-test ratio can help you gauge how capable a company is of meeting its financial obligations over the short term.
Check out what the acid-test ratio is, how to calculate and interpret it and what its limitations are.
What is the acid-test ratio
The acid-test ratio is a financial ratio that compares a company’s quick assets with its current liabilities. For this reason, the acid-test ratio is also known as the quick ratio. The quick assets of a company include its cash, accounts receivables and marketable securities — essentially collating all the assets that can be quickly converted into cash.
By checking the acid-test ratio of a company before investing in it, you can assess how capable the entity is of meeting its current liabilities using its quick assets alone. This gives you more clarity about the company’s liquidity.
The formula for calculating the acid-test ratio
The formula for calculating the acid-test ratio is present in its definition itself. Since the ratio compares a company’s quick assets with its current liabilities, the formula for the acid-test ratio is as follows:
Acid-test ratio = (Cash + Accounts receivable + Marketable securities) ÷ Current liabilities |
The numerator in the above formula represents a company’s quick assets. Do note that inventory is not included in the quick assets of a company. It is, therefore, not used in calculating the acid-test ratio. However, the inventory is still a part of the current assets of a company. So, it is essential to compute the company's current ratio.
Calculating the acid-test ratio: An example
Let us discuss a hypothetical example to better understand how the computation of the acid-test ratio works. Consider the following data from a company’s financial statements for a given financial year.
- Cash and cash equivalents: Rs. 50,000
- Accounts receivable: Rs. 40,000
- Marketable securities: Rs. 1,50,000
- Inventory: Rs. 2,50,000
- Other current assets: Rs. 30,000
- Current liabilities: 3,00,000
Plugging these values into the formula for the acid-test ratio, we have the following calculations:
Acid-test ratio:
= (Cash + Accounts receivable + Marketable securities) ÷ Current liabilities
= Rs. (50,000 + 40,000 + 1,50,000) ÷ Rs. 3,00,000
= Rs. 2,40,000 ÷ Rs. 3,00,000
= 0.80
How to interpret the acid-test ratio
The acid-test ratio tells you how much money the company has in its quick assets to repay every rupee of its current liabilities. Ideally, the ratio should at least be 1:1, meaning that the company must have adequate quick assets to cover its current liabilities. This indicates that the company has sufficient liquidity.
It also means that a higher value of the acid-test ratio is better. For instance, a quick ratio of 2.40 means that the company has Rs. 2.40 in quick assets for every Re. 1 of its current liabilities. In other words, it means that the company can repay its current liabilities 2.4 times over with its existing quick assets.
Conversely, an acid-test ratio below 1 means that the company does not have sufficient liquidity. In the example discussed in the previous section, the calculated acid-test ratio of 0.80 indicates that the company only has Rs. 0.80 to repay every Re. 1 of its current liabilities. This represents poor financial liquidity and may become an issue if the company is unable to raise more quick assets within a short period.
That said, when you are analysing a company’s liquidity, it is best to also look into the acid-test ratio values of its peers. This gives you a better idea of where the company stands when compared with the industry standards or benchmarks. Companies in some industries like retail, automotive, or manufacturing sectors may have low acid-test ratios as the norm because inventory makes up a large portion of their current assets. Since the inventory is not considered in the quick ratio, such companies may typically have a low acid-test ratio.
Limitations of the acid-test ratio
While the acid-test ratio can be extremely beneficial to quickly gauge a company’s short-term liquidity, it is not without its limitations. Some drawbacks of this ratio that you need to be aware of include:
- Not considering inventory: The acid-test ratio excludes inventory, which is one of its biggest flaws. This can present a skewed view of a company’s liquidity, particularly for companies in sectors with high inventory levels. By ignoring the inventory for such companies, you may inadvertently judge their liquidity (or lack thereof) too harshly.
- No information about cash flows: Cash flows are fundamental to ensuring liquidity. Unfortunately, the acid-test ratio does not include cash flows in its calculation at all. By studying this ratio, you cannot assess the frequency, level, or timing of a company’s cash flows. This prevents you from assessing the liquidity comprehensively.
- Limited view of liquidity: While the quick ratio may be suitable to assess the liquidity of companies with low inventory levels or those with easily available cash flows, it only has limited scope for other entities. This is why it is best to use the acid-test ratio alongside other liquidity metrics that offer more clarity on the nuances of debt management.
- Optimistic view on accounts receivable: Another major drawback of the acid-test ratio is that it classifies a company’s accounts receivables as quick assets. Practically, such debts may not always be easy to realise. Some of the accounts receivable may be difficult to collect, while others may become bad debts as well.
Conclusion
Now that you know what the acid-test ratio is and how you can compute it using the details in a company’s balance sheet, you can better assess an entity’s liquidity. That said, it is always smarter to use the acid-test ratio in combination with other metrics to get a more comprehensive overview of a company’s financial stability and liquidity. Some such metrics include the current ratio, debt-to-equity ratio, Return on Equity (RoE) and inventory turnover ratio.
