What is the 'Acid-Test Ratio'
The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its immediate liabilities. Commonly known as the quick ratio, this metric is more robust than the current ratio, also known as the working capital ratio, since it ignores illiquid assets such as inventory.
BREAKING DOWN 'Acid-Test Ratio'
Companies with an acid-test ratio of less than 1 do not have the liquid assets to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that current assets are highly dependent on inventory.
This is not a bad sign in all cases, however, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid-test ratios without necessarily being in danger. At the time of writing, Wal-Mart Stores Inc.'s (WMT) acid-test ratio is 0.20, while Target Corp.'s (TGT) is 0.40. The companies' current ratios are 0.90 and 1.20, respectively. In such cases other metrics should be considered, such as inventory turnover. The acceptable range for an acid-test ratio will vary by industry, and comparisons are most meaningful within a given industry.
For most industries, the acid-test ratio should exceed 1. Then again, a very high ratio is not always an unalloyed good. It could indicate that cash has accumulated and is idle, rather than being reinvested, returned to shareholders or otherwise put to productive use. Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits.
Acid-test Ratio Calculation
The numerator of the acid-test ratio can be defined in various ways, but the main consideration should be gaining a realistic view of the company's liquid assets. Cash and cash equivalents should definitely be included, as should short-term investments, for example, marketable securities. Accounts receivable are generally included, but this is not always appropriate. In the construction industry accounts receivable may take a long time to recover, and their inclusion could make a firm's financial position seem much more secure than it is.
Another way to calculate the numerator is to take all current assets and subtract illiquid assets. Most importantly, inventory should be subtracted, keeping in mind that this will negatively skew the picture for retail businesses, as in the cases of Walmart and Target mentioned above. Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments and deferred tax assets.
The denominator should include all current liabilities, which are debts and obligations that are due within one year.
It is important to note that time is not factored into the acid-test ratio. If a company's accounts payable are nearly due but its receivables won't come in for months, that company could be on much shakier ground than its ratio would indicate. The opposite can also be true.
Real World Example
A company's acid-test ratio can be calculated using its balance sheet. Below is an abbreviated version of Apple Inc.'s (AAPL) balance sheet for the quarter ended June 27, 2015, showing the components of the company's current assets and current liabilities (all figures in millions of dollars):
|Cash and cash equivalents||15,319|
|Short-term marketable securities||19,384|
|Accounts receivable, less allowance of $83||10,370|
|Deferred tax assets||5,010|
|Vendor non-trade receivables||9,537|
|Other current assets||9,291|
|Total current assets||70,953|
|Current portion of long-term debt||2,500|
|Total current liabilities||65,285|
To obtain the company's liquid current assets we add cash and cash equivalents, short-term marketable securities, accounts receivable and vendor non-trade receivables. We then divide current liquid current assets by total current liabilities to calculate the acid-test ratio.
Apple's acid-test ratio = ( 15,319 + 19,384 + 10,370 + 9,537 ) / 65,285 = 0.84
Not everyone calculates this ratio the same. Reuters, for example, reports a quick ratio of 1.06 for Apple's most recent quarter, implying that they simply subtracted inventories from total current assets. There is no single, hard-and-fast method for determining a company's acid-test ratio, but it is important to understand how data providers arrive at their conclusions.
The Acid-test Gold Standard
Finally, a note on the term "acid test." One method for testing whether a metal is real gold is to apply acid to it. If certain mixtures corrode the metal, it is not gold. The more resistant to corrosion the gold is, the higher the purity. Following the Gold Rush, the term came to refer to any test that indicates an object's authenticity, veracity, or worth. In this case, it can let you know if a shiny investment opportunity is actually fool's gold.
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