What Is an Acid Test Ratio?

What Is an Acid Test Ratio?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

The Acid Test Ratio, sometimes referred to as the quick ratio, is a financial metric widely used by businesses to gauge their short-term liquidity position. It determines how well a company can use its quick assets to cover its current liabilities. Quick assets typically include cash, marketable securities, and accounts receivables, which can be converted into cash at a short notice. The higher the ratio, the healthier the company’s liquidity position. To calculate it, divide the sum of cash, marketable securities, and accounts receivables by the current liabilities.

Related Questions

1. What does a high Acid Test Ratio indicate?

A high Acid Test Ratio shows that a company is well-positioned to meet its short-term obligations. It means the company has enough quick assets to cover its current liabilities without selling inventory. This is generally viewed as a sign of strong financial stability.

2. Is a lower Acid Test Ratio dangerous for a company?

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A lower Acid Test Ratio could indicate potential trouble for a company in fulfilling its immediate financial obligations. If a company’s Acid Test Ratio is less than 1, it may not be able to pay off its current liabilities, hence can be a warning sign for investors or creditors.

3. How does the Acid Test Ratio differ from the Current Ratio?

Both the Acid Test Ratio and Current Ratio are measures of a company’s liquidity. The main difference is that the Acid Test Ratio excludes inventory from its calculation, making it a more stringent measure. This is because it only considers those assets that can be quickly converted into cash.

4. Can the Acid Test Ratio vary across industries?

Yes, the acceptable Acid Test Ratio can vary across industries. For industries whose operations can quickly turn inventories into cash, a relatively lower Acid Test Ratio might not be a concern. On the other hand, in sectors where inventory conversion is typically slower, a higher Acid Test Ratio is more desirable.

5. How often should a company evaluate its Acid Test Ratio?

Regular evaluation of the Acid Test Ratio is recommended, although it depends on the company’s financial condition and the nature of its industry. Most companies track this ratio quarterly or annually when preparing their financial statements. However, if a company is going through a challenging financial phase, it might need to monitor its Acid Test Ratio more frequently.