Acid-Test Ratio

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Acid-Test Ratio

During the Goldrush of the 1800s in the American West, prospectors and dealers needed a way of distinguishing real gold from other metals. One way that proved to be efficient and accurate, was the use of Nitric acid to test the purity of the gold. This chemical is known to dissolve other metals more rapidly than gold. Therefore, to confirm if the metal being sold or bought was actual gold, they would pass it through ‘the acid test’.

The term went on to be used in business to determine how well a company is doing in terms of managing its cash flow. The Acid-Test ratio was thus created to determine the general financial health of a company by determining if it has enough quick assets to settle its current liabilities.

Acid-Test Ratio: Defined

The Acid-Test ratio also referred to as the quick ratio, compares a company’s short-term assets in relation to its short-term liabilities. The ratio provides a quick measure of whether the company has enough cash at hand to pay for its immediate liabilities such as short term debt in the form of bills.

This means that when calculating the Acid-Test ratio, assets such as inventory are excluded from the calculation. This is due to the fact that such assets take time to liquidate. Examples of other such assets that can be excluded from the Acid-Test ratio include real estate, vehicles, and custom machinery unique to particular manufacturing industries.

The Acid-Test ratio can thus be viewed as a quick liquidity test. It is calculated by taking a company’s current assets and dividing it by the value of its current liabilities.

Calculating an Acid-Test Ratio

When calculating the Acid-Test ratio, the following formula is used.

Acid-Test Ratio = Current Assets / Current Liabilities

Acid-Test Ratio = (Cash & Cash Equivalent + Marketable securities + Accounts Receivable) / (Current Liabilities)

Further elaborating on each term, the cash and cash equivalents are the items on a company’s balance sheet that are in the form of hard cash or can quickly be converted into cash. With respect to cash equivalents, they can be funds in savings accounts, short term treasury bills, and government bonds.

With respect to marketable securities, these are the short term liquid securities that can be liquidated rather quickly for cash. Such financial instruments are held by companies to hold their cash reserves rather than having idle funds in bank accounts. Marketable securities can be utilized when funds are needed quickly. They can be easily liquidated on a public stock exchange and include financial instruments such as shares, treasury bills, indices, and ETFs.

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Accounts receivable is the money owed to the company by other firms or individuals as a result of goods and services that have been rendered. Therefore, outstanding invoices fall into this category and are classified as current assets since the customer is legally obligated to pay the debt.

In the denominator of the Acid-Test ratio, we have the current liabilities. These are defined as the short-term financial obligations that are due within one year or a financial operating cycle. Examples of current liabilities include bank overdrafts, accounts payable, taxes owed (sales, payroll or income taxes), loans, and accrued expenses.

What Does the Acid-Test Ratio Tell Us?

As with all ratios, the Acid-Test ratio provides a quick analysis of the health of the company and its ability to settle short term debts. Therefore, a ratio of 1 indicates the company can pay all its liabilities in a break-even scenario.

An Acid-Test Ratio of less than one shows that the company does not have enough liquid assets to service its current liabilities. However, this is not always a bad thing in cases where businesses depend on inventory. For example, retail stores such as Wal-Mart, Amazon and other retail outlets, rely heavily on their inventory. It is therefore not surprising to find such companies with an Acid-Test ratio of less than 1.

In other industries, an Acid-Test ratio of more than one is preferred. It shows that business is good and the company can cover its liabilities without much stress.

However, too high of an Acid-Test ratio can mean the company is generating high cash flows. If the company is public in the stock markets, a high Acid-Test might indicate that it might be time to distribute dividends. If the company is yet to go public, a high Acid-Test ratio might be the signal needed for the company to use its cash reserves to expand on its business and other investments.

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Applications

As mentioned above, the Acid-Test ratio is used to determine a company’s ability to pay off its current liabilities. The higher the ratio, the more likely the company can cover its short term liabilities.

Examples

For example, let us take the hypothetical situation of three companies with the following balance sheets.

Company ACompany BCompany C
Cash and Equivalents$30,000$48,000$15,000
Short-term marketable
securities
$12,500$32,000$43,000
Accounts receivable$23,000$10,000$12,000
Inventory$7,500$3,200$21,000
Accounts payable $25,500$13,500$3,000
Long-term debt and other
liabilities
$39,000$42,000$8,500
A.T.R (Acid-Test Ratio)1.0151.626.08

A.T.R (Company A) = (30,000 + 12,500 + 23,000) / (25,500 + 39,000) = 1.015
A.T.R (Company B) = (48,000 + 32,000 + 10,000) / (13,500 + 42,000) = 1.62
A.T.R (Company C) = (15,000 + 43,000 + 12,000) / (3,000 + 8,500) = 6.08

Limitations

As with all ratios, the Acid-Test-Ratio has its drawbacks. To begin with, the ratio is not enough to determine the liquidity of a company. Other ratios are often used together with the Acid-Test ratio to provide a better measure of liquidity. This includes ratios such as the current ratio which includes current inventories in its calculations.

Secondly, the Acid-Test ratio does not provide information regarding the timing and level of cash flows. The availability of liquidity with time is very important to determine if a company can meet its debt obligations.

Thirdly, accounts receivable are assumed to be easily available. However, this is not the case. Customers sometimes delay their payments or renege on doing so completely resulting in additional costs implementing debt collection.

How do Companies Improve their Acid-Test Ratios?

One of the most basic methods for a company to increase its Acid-Test ratio is to keep its liabilities in check. This means paying off debts and thus lowering the denominator in the calculations of the Acid-Test ratio.

Secondly, a company can employ various methods such as online marketing to increase sales of the inventory not included in the Acid-Test ratio calculations. By increasing sales, more cash will be available to cover short term obligations.

Thirdly, decreasing the time it takes to collect on accounts receivable will improve the cash flow. Additionally, credit should only be availed to reliable customers who pay on time.

Concluding Thoughts

In conclusion, the Acid-Test ratio provides a quick measure of a company’s ability to use its current assets to offset liabilities. The Acid-Test ratio does not include inventory in its calculation and therefore should be used in conjunction with other ratios to determine the overall health of a company.

An Acid-Test ratio of 1 is considered normal and a ratio greater than 1 is ofter preferred. In the latter case, it means a company can meet its liabilities comfortably. However, a very high Acid-Test ratio can be an indicator that the company needs to think of new ways of investing in its abundant cash flows.

In the case of an Acid-Test ratio of less than one, it means the company cannot fully pay its current liabilities without selling more inventory or taking on more liabilities such as a loan.

Therefore, and just like during the Goldrush period of the 1800s, the Acid-Test ratio provides a quick analysis of a company’s liquidity.

What is an Acid-Test Ratio?

An Acid-Test ratio, also referred to as the quick ratio, compares a company’s short-term assets in relation to its short-term liabilities.

What information does the Acid-Test Ratio provide?

The Acid-Test ratio is a quick way of determining the liquidity of a company.

How do I calculate the Acid-Test ratio?

The Acid-Test ratio is calculated by dividing current assets by the current liabilities.

What is one drawback of the Acid-Test ratio?

One major drawback of the Acid-Test ratio is that it does not include inventory in its calculations. It ignores the fact that sometimes, inventory can be quickly converted into cash.

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