The acid test ratio, or quick ratio, measures a company’s liquidity by assessing its ability to meet short-term liabilities using its most liquid assets. It is calculated by dividing the sum of cash, cash equivalents, and marketable securities by the company’s current liabilities. Ideally, an acid test ratio of 1:1 is considered healthy, indicating that the company has sufficient liquid assets to cover its short-term obligations without relying on inventory or other less liquid assets.
This article explains the acid test ratio with emphasis on its formula, calculation, and interpretation.
What is the acid test ratio?
The liquidity of a company is an effective method by which you can assess the financial health of any company. If you are an investor who wishes to invest in stocks or stock-related instruments like mutual fund schemes, it is important to have an efficient method to determine how financially strong a company is. The acid test ratio proves to be a good tool to assess a company’s short-term financial strength by measuring its liquidity.
As there are various ways to measure a company’s present liquidity, it is important to understand the acid test ratio meaning. Essentially, the acid test ratio is a financial analysis tool that is used to measure a company’s ability to use its quick assets or current liquid assets to fulfil any immediate financial obligations. It is important to stress that the acid test ratio does not account for inventory in its calculation. This is because inventory is relatively less liquid than other current assets, especially companies engaged in the retail or industrial economic sectors.
An easy way to grasp the meaning of the acid test ratio is to consider that it uses only the most current assets of the company that can be turned into cash. Typically, the balance sheet of a company will tell you whether it has sufficient cash on hand to take care of its present debt. The acid test ratio is often compared with another liquidity ratio, the current ratio. However, the acid test ratio has proven more useful since it excludes inventory which may be difficult to liquidate at short notice.
Example of acid test ratio
To fully grasp the acid test ratio, you can learn about it from an illustrated example. The example shows you how the acid test ratio calculation works and this is important if you are an investor who wishes to invest in stocks or sign up for any mutual fund schemes through any platform, like say, the Bajaj Finserv Mutual Fund Platform. As mentioned earlier, the acid test ratio gives you a vital clue about the financials of a company. Here is an example that should make the concept clear:
Let us imagine a company called Infotech ABC has its current assets valued at Rs. 25 Crore (this includes cash & cash equivalents, short-term investments, and receivables). The current liabilities of the company are valued at Rs. 27 Crore. According to the acid test ratio formula, the current assets are divided by the current liabilities. The equation you get is the following:
250,000,000/270,000,000 = 0.92
The value that arises from the calculation is below 1.0. This is indicative of the company being tight where its liquidity is concerned. Hence, it may face trouble meeting its current financial commitments.
How does acid test ratio work?
The acid test ratio works by a calculation of a company’s current assets divided by the company’s current financial liabilities. Basically, the acid test ratio decides whether a company has enough cash or liquid assets to make specific compulsory cash payments in the near future.
When you look at a company’s balance sheet or financial documents (quarterly or annual reports), you will come across certain variables that you must use in your calculation of the acid test ratio. To consider the company’s total current assets, you must find the variables of cash and cash equivalents, accounts receivable, and marketable securities. To consider the company’s current liabilities, you must find the figure listed under the heading “current liabilities”.
To understand acid test ratio meaning more clearly, you should have an idea of sections of the acid test ratio formula. Current assets are those that can be converted into cash within a year, and current liabilities make up debts that are due within a year. In a best-case financial scenario, a company should have an acid test ratio of 1 or more. This shows that the company has enough funding to pay its current bills. If a company’s acid test ratio is lower than 1, it means that the company may not have enough cash to pay its short-term bills. In such a situation, the company may rely on its inventory, such as retailers.
Formula for acid test ratio
The formula for calculating the acid test ratio is given below:
Acid Test Ratio = Current Assets/Current Liabilities
In the formula, current assets include the following:
- Cash and cash equivalents: These are the most liquid assets of a company. They include term deposits with maturity periods of less than 3 years, savings accounts, etc.
- Marketable securities: These are liquid financial instruments that can be changed into cash at short notice.
- Accounts receivable: These make up the funds owed to the company by the company’s customers receiving the goods/services of the company.
In the formula, the current liabilities are any financial commitments that the company has to fulfil or any debts the company has to pay within a year. It is important to note that if the inventory figures are listed under the broad category of the assets of a company, these must be subtracted from the total current assets as they are excluded from the acid test ratio calculation.
How to calculate acid test ratio?
How to calculate the acid test ratio is easy. All the information you require to make this calculation is available on the company’s balance sheet. The information includes the current assets made up of cash and cash equivalents, accounts receivable, and marketable securities. The current liabilities comprise accounts payables, short-term debt, and accrued liabilities and other debts. The acid test ratio is calculated by dividing the total assets by the total liabilities.
Calculation of acid test ratio = Total assets/total liabilities
Why need to calculate the acid test ratio?
Calculating the acid test ratio is crucial for assessing a company’s ability to meet its short-term financial obligations without relying on inventory sales. Unlike other liquidity ratios, the acid test ratio focuses on the most liquid assets, such as cash, cash equivalents, and marketable securities, providing a more accurate picture of a company’s financial health. By calculating this ratio, investors, creditors, and management can determine if the company has enough liquid assets to cover immediate liabilities. A low acid test ratio may indicate potential liquidity problems, while a high ratio suggests financial stability and a strong ability to meet short-term obligations.
What is a good acid-test ratio?
A good acid-test ratio typically ranges from 1:1 to 2:1. This indicates that a company has enough liquid assets, such as cash, cash equivalents, and marketable securities, to cover its short-term liabilities without relying on inventory. A ratio of 1:1 suggests that the company can exactly meet its short-term obligations.
If the ratio exceeds 1:1, it usually points to strong liquidity, suggesting the company can easily cover its liabilities and may have extra reserves. However, an excessively high ratio may indicate underutilisation of resources, which could be a sign of inefficient cash management.
Interpretation of acid test ratio
If you are investing in mutual funds that have company stock or in the direct equity of companies, you may want to calculate the acid test ratio to make potentially profitable investment decisions. Besides the calculation you make, the interpretation of this calculation is important when you are deciding whether a company is financially sound regarding its liquidity. The following aspects of the acid test ratio help you in understanding what the ratio and its interpretation means:
1. Acid test ratio of 1 or above:
If the acid test ratio is more than 1, the company has enough liquid assets to pay short-term debts.
2. Acid test ratio of less than 1:
If the acid test ratio equals less than 1, the company may find it hard to pay its current debts with its most liquid assets.
3. Comparison with industry benchmarks:
The interpretation of the acid test ratio is used to compare a company to other companies within its industry or sector. A company ratio that is below average for its industry may not necessarily be considered low if the industry norm is low.
4. Time-based trends:
Monitoring the trend of an acid test ratio over many periods may tell you about the financial situation of a company. For example, a decreasing ratio may indicate that a company’s liquidity situation is worsening. On the other hand, if the ratio moves higher over time, it suggests a positive trend for a company’s financials.
5. Situational analysis:
Every company is unique. Different factors affect the financial performance of companies in different ways depending on companies’ situations. Given this, the acid test ratio must be interpreted based on the company’s unique financial position. Industry cycles, seasonality, and certain business strategies tend to affect ratios of different companies.
Drawbacks of the acid test ratio
The quick ratio or the acid test ratio is an effective measure of short-term liquidity. This is especially valuable if you are investing in equity-based mutual fund schemes or stocks and are evaluating companies based on their financials. As valuable as the ratio may be in deciding a company’s financial background, the metric has some limitations that are mentioned below:
1. Overly conservative
The acid test ratio tends to be a conservative metric as it disregards inventory in its calculation.
2. Ignores the timing of cash flows
The acid test ratio does not account for cash flow timing. This is an important factor as all accounts receivable may not be collectible in the short run.
3. Lack of industry context
Acid test ratios vary from one industry to another. Therefore, industry norms must be taken into account for proper acid test ratio meaning.
4. Dependence on receivables
The acid test ratio can be artificially inflated due to a high proportion of accounts receivable. This may lead to the potential misinterpretation of results.
5. Ignores future cash sources
The calculation of the acid test ratio is focused on current assets of a company and its current liabilities.
Difference between current and acid test ratio
The current ratio and acid test ratio are both liquidity metrics used to assess a company’s ability to meet short-term obligations, but they differ in the types of assets considered.
The current ratio is calculated by dividing a company’s total current assets by its current liabilities. It includes all assets that are expected to be converted into cash within a year, such as cash, accounts receivable, inventory, and prepaid expenses. While this ratio provides a broad measure of liquidity, it may be inflated by the inclusion of inventory, which could be difficult to quickly liquidate in some cases.
The acid test ratio, also known as the quick ratio, is a more conservative measure. It excludes inventory from current assets and only includes the most liquid assets, such as cash, cash equivalents, and marketable securities, in the numerator. This makes the acid test ratio a more stringent measure of a company’s ability to cover short-term liabilities without relying on inventory or other less liquid assets.
In summary, while both ratios indicate liquidity, the acid test ratio provides a more accurate picture of a company’s short-term financial health by focusing on assets that are easily converted to cash. A higher current ratio may indicate good liquidity, but a low acid test ratio could signal potential liquidity concerns.
Key takeaways
- The acid test ratio, or quick ratio, makes a comparison of a company’s current assets and its current liabilities to find out if the company has enough funds to settle any short-term debts.
- The acid test ratio does not consider inventory in its calculation, as inventory is difficult to liquidate quickly. This is the reason that the acid test ratio is used more than the current ratio (that does not disregard inventory) to assess a company’s ability to pay off its short-term debts.
- A ratio of 1 or more is considered potentially favourable in that it means a company is cash-rich and can afford to pay its bills.
If the ratio is less than 1, it means that the company finds it difficult to pay its bills. However, in some cases, this may also mean that the company depends more on its inventory.
Conclusion
The acid test ratio is an appropriate measure for the assessment of a company’s financial health. While it does not consider inventory in its calculation, it gives you a picture of a company’s liquidity compared to other companies in its industry. Hence, while interpreting the acid test ratio, you must view the ratio according to particular industry norms. Although providing you with valuable information about a company’s financial status, the acid test ratio is not the only indicator of financial strength and may have some limitations to ponder on.
In the world of investing, especially if you are venturing into equity markets, any indicator of a company’s strength and performance is welcome in your evaluation. Needless to say, researching a company before you invest in it, whether searching for mutual fund investment on the Bajaj Finserv Mutual Fund Platform, or in the stock market, is essential. On the Bajaj Finserv Mutual Fund Platform (with more than 1000 mutual fund schemes to choose from), your mutual fund investing journey starts with a bang! You get to select mutual funds with the help of efficient calculators that predict your returns, as well as have the chance to invest in mutual funds based on your unique financial personality.
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