Determining Acid-Test Ratio
The acid-test ratio is a measure of a company's liquidity, although it is mostly used when a company is believed to be illiquid. It is a ratio that measures a company's ability to meet its current obligations without disposing of its inventory, or conversely how quickly a company's assets can be turned into cash. It is also is known as the quick ratio, or simply the acid ratio.
It is considered a highly reliable indicator of a company's financial strength and its ability to meet its short-term obligations, regardless of what it is called. Inventory can sometimes be difficult to liquidate, so in calculating the acid-test ratio, inventory is deducted from current assets before they are compared with current liabilities. This is what distinguishes it from the so-called current ratio, which is a ratio of current assets to current liabilities. Movements in this ratio are often indications of solvency, or over trading.
Potential creditors like to use the acid-test ratio because it exposes what would happen if a company had to pay off its debts in the worst possible circumstances.
The acid-test ratio can be calculated in two ways, both essentially reaching the same conclusion. The most common calculation is:
If, for example, current assets total $7,700, inventory $1,200, and current liabilities $4,500, then:
An alternative formula excludes inventory altogether, defining assets as cash, receivables, and short-term investments. The sum of the three is then divided by the total current liabilities:
If, for example, cash totals $2,000, receivables, $3,000, short-term investments $1,000, and liabilities $4,800, then:
There are still two other ways to measure liquidity, although neither is as popular as the acid-test ratio. The cash ratio is cash plus marketable securities divided by current liabilities, while net quick assets is cash plus accounts receivable and marketable securities, minus current liabilities.
An acid-test ratio of no less than 1:0 is the general norm, depending on the industry. It means a company has a unit's worth of easily-convertible assets for each unit of its current liabilities. A high ratio reflects a sound, well-managed company in no danger of imminent collapse, even in the event its sales came to a stop, while a ratio of less than 1:0 indicates the company could not pay its current liabilities if the need arose. A ratio of 1:1 is generally acceptable to creditors, but acceptable ratios vary by industry, as do almost all financial ratios. They must be read in the context of the businesses to which they apply.
A falling acid-test ratio and a stable current ratio could indicate that a company has built up too much inventory. It could also suggest, however, that the company has greatly improved its collection system. An acid-test ratio that is notably lower than the working capital ratio often means that inventory makes up a large proportion of current assets, as occurs in retailing, for example.
Comparing acid-test ratios over an extended period can signal trends developing in a company. Modest fluctuations do not automatically spell trouble, but exploring the reasons for changes can help find ways to ward off potential problems. Like the current ratio, the acid-test ratio is an indicator, and a company can manipulate its figures to make it look robust at a given time. Investors who suddenly become keenly interested in a company's acid-test ratio may be anticipating a downturn in the company's business, or in the general economy.
Business Owner's Toolkit: www.toolkit.cch.com