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What is the acid test ratio?
How do you calculate it and what does it tell you?
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Table of Contents
What Is The Acid Test Ratio
The acid test ratio is a measure of a company’s liquidity intended to assess its ability to use current assets to pay for its short-term obligations.
The acid test ratio is similar to the current ratio where you compare the ratio of the company’s current assets and current liabilities.
However, to perform the acid test, you will only consider the current assets that are convertible to cash within 90 days or less.
On the other hand, the current ratio considers current assets that are convertible into cash within a year or less.
Many analysts and financial professionals consider the acid test to be more indicative of a company’s liquidity and financial health.
That is the case because you’re only considering current assets that are highly liquid and excluding those that are less liquid, like inventory.
If a company has an acid test ratio of 1.0 or more, it means that it has at least $1.00 of highly liquid current assets to cover its financial obligations within the year.
However, if the acid test ratio is below 1.0, it means that the company’s highly liquid current assets are lower than its short-term debt.
Current Assets
To calculate the acid test ratio, you’ll need to consider current assets that are convertible into cash within 90 days or less.
The current assets that are considered for the acid test ratio are:
- Cash
- Cash equivalents
- Marketable securities
- Accounts receivables
- Liquid investments
Current Liabilities
The current liabilities that are considered for the acid test ratio are all liabilities that are owed or payable within one year or less.
The current liabilities for the acid test ratio include:
- Accounts payable
- Deferred revenues
- Taxes payable
- Wages payable
- Short-term debt
Any financial obligation due within a year is considered in the current liabilities.
Why Calculate Acid Test Ratio
Calculating the acid test ratio can provide useful information about a company’s liquidity.
The idea behind this ratio is to see if the company has enough short-term assets readily convertible into cash within 90 days or less to pay for its current liabilities payable within 12 months or less.
Since this test is more conservative than the current ratio, many analysts prefer calculating the acid test ratio to assess a company’s liquidity.
In fact, the acid test ratio does not consider inventory as part of the current assets.
You will only consider cash, cash equivalents, marketable securities, and investments convertible into cash within 90 days.
If the company’s acid test ratio is above 1.0, it means the company has more than $1.00 to cover every $1.00 of current liability.
On the other hand, if the company’s acid test ratio is below 1.0, you should consider doing further investigation on the company’s liquidity to see if there are any underlying concerns or risks.
Acid Test Ratio Formula
You’ll need to use the acid test formula to calculate the acid test ratio.
The acid test formula can be presented as follows:
ATR = (C + CE + AR + STI) / Current Liabilities
- AT = Acid Test Ratio
- C = Cash
- CE = Cash Equivalents
- AR = Accounts Receivable
- STI = Short-Term Investments
To calculate the acid test ratio, you should add the cash, cash equivalents, and accounts receivables and divide it by the sum of accounts payable, deferred revenue, taxes payable, and other short-term liabilities.
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Acid Test Ratio Interpretation
The acid test ratio lets you see if a company has sufficient highly liquid assets to pay for its short-term liabilities.
When a company has an acid test ratio of 1.0, it means that it has $1.00 of highly liquid current assets convertible into cash within the next 90 days to pay for every $1.00 of current liabilities owed within the next twelve months.
If a company has an acid test ratio of 3.0, it means that it has $3.00 of highly liquid assets to pay for all its current liabilities.
This may suggest that the company may not be using its current assets efficiently to generate a higher return for its shareholders.
On the other hand, if a company has an acid test ratio below 1.0, it means the company does not have enough highly liquid current assets to pay for all of its current liabilities due within the year.
However, it’s important to consider the acid test ratio and other financial measures to understand the company’s financial position better.
Looking at the acid test ratio alone may not give you an accurate representation of the company’s financial health and liquidity.
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Acid Test Ratio Limitations
Just like most other financial ratios, the acid test ratio has limitations that you should be aware of.
First, it’s important to remember that you should not look at the acid test ratio in isolation as you may not get the right liquidity perspective.
You should assess the acid test ratio along with other financial ratios allowing you to have a more holistic view of the company’s financial health.
Also, since the acid test ratio does not consider inventory, companies that can quickly turn over their inventory may be disadvantaged.
If a company can quickly turn its inventory into cash, the acid test ratio may be too conservative in measuring its liquidity.
Another limitation of the acid test ratio is that we must assume that the company’s accounts receivables can be readily turned into cash within 90 days.
However, this may not be the case for all companies.
If the company has a hard time converting its accounts receivables into cash, then the acid test ratio may paint a rosier picture of the company’s liquidity than the reality.
Acid Test Ratio Example
Let’s look at an example of acid test ratio to better understand how it works.
Imagine there’s a company with the following financial characteristics:
- Cash = $200,000
- Marketable securities = $500,000
- Accounts receivables = $800,000
- Inventory = $1,500,000
- Accounts payable = $1,500,000
- Taxes payable = $100,000
- Deferred revenue = $400,000
First, we need to calculate the current assets by excluding inventory (this gives us $1,500,000).
Then, we calculate the total current liabilities (giving us $2,000,000).
Next, we can calculate the acid test ratio by dividing $1.5 million by $2.0 million, giving us 0.75.
This means the company has $0.75 of highly liquid current assets to cover its short-term liabilities.
If we were to calculate the current ratio by considering inventory, we would have a current ratio of 1.5 (which appears to be more healthy than the acid test ratio).
Since the acid test ratio is below 1.0, it’s best further to assess the company’s financial position and liquidity to see if there are any underlying risks.
Acid Test Ratio FAQ
What does acid test ratio mean?
The acid-test ratio is a liquidity ratio allowing you to measure a company’s ability to pay for its current liabilities using its short-term assets.
If the company has an acid test ratio greater than 1.0, it means that it has more current assets to pay for its current liabilities.
What is the difference between acid test ratio and current ratio?
The main difference between the acid test ratio and the current ratio is the inclusion or not of inventory in the “current asset” bucket.
When you calculate the current ratio, you’ll include all current assets, including inventory.
This includes cash, cash equivalents, marketable securities, accounts receivables, and inventory.
On the other hand, when you calculate the acid test ratio, you include the current assets that are convertible into cash within 90 days and exclude inventory.
This includes cash, cash equivalents, marketable securities, and accounts receivables.
The current liabilities are the same for both the acid test ratio and the current ratio.
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What is a good acid test ratio?
There’s no cookie-cutter answer for all companies.
A good acid test ratio should generally be around 1.0 to 1.5.
However, it’s important to compare a company’s acid test ratio with its industry and look at the trends over time to see what’s a good acid test ratio.
A company having a much higher ratio than the industry average is probably not utilizing its current assets effectively.
Similarly, an acid test ratio that is too low can be a sign of liquidity issues requiring more investigation.
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Takeaways
So there you have it folks!
What is the acid test ratio?
In a nutshell, the acid test ratio is a liquidity ratio allowing you to measure a company’s ability to pay for its short-term liabilities using its short-term assets.
This ratio is a more conservative liquidity measure as you will only consider the current assets that can be converted into cash within 90 days.
Essentially, you are looking to see if you have enough highly liquid assets to cover your current liabilities.
Now that you know what the acid test ratio is, how to calculate it, and what it measures, good luck with your research!
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