Acid-Test Ratio


DEFINITION of '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.

Calculated by:

Acid-Test Ratio


Loading the player...

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
     Inventories 2,042
     Deferred tax assets 5,010
     Vendor non-trade receivables 9,537
     Other current assets 9,291
          Total current assets 70,953
     Accounts payable 26,474
     Accrued expenses 22,724
     Deferred revenue 9,088
     Commercial paper 4,499
     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.

  1. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  2. Current Assets

    A balance sheet account that represents the value of all assets ...
  3. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ...
  4. Working Capital

    Working capital is a measure of both a company's efficiency and ...
  5. Current Liabilities

    A company's debts or obligations that are due within one year. ...
  6. Liability

    A company's legal debts or obligations that arise during the ...
Related Articles
  1. Professionals

    Warning Signs Of A Company In Trouble

    Don't let your clients go down with ship! Learn how to escape sinking with these tips.
  2. Investing Basics

    Do Your Investments Have Short-Term Health?

    If a company is strong enough to survive tough times, it is more likely to provide long-term value.
  3. Markets

    What Is The Quick Ratio?

    Find out about this liquidity indicator and how it's used.
  4. Markets

    How To Analyze A Company's Financial Position

    Find out how to calculate important ratios and compare them to market value.
  5. Fundamental Analysis

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  6. Options & Futures

    Advanced Financial Statement Analysis

    Learn what it means to do your homework on a company's performance and reporting practices before investing.
  7. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  8. Markets

    Operating Cash Flow: Better Than Net Income?

    Differences between accrual accounting and cash flows show why net income is easier to manipulate.
  9. Investing Basics

    The Best Litmus Test Of A Company's Risk? The Acid Test

    The acid test measures a company’s short-term liquidity.
  10. Investing Basics

    How To Efficiently Read An Annual Report

    Annual reports are clearly prepared without any intent to deceive or mislead investors. Still, investors should read them with a dose of skepticism.
  1. How can I calculate the acid test ratio in Excel?

    The acid test ratio, commonly called the quick ratio, is a useful accounting metric used to measure a company's ability to ... Read Full Answer >>
  2. What is the difference between the acid test ratio and working capital ratio?

    To determine a company’s ability to meet its financial obligations, individuals in accounting as well as interested investors ... Read Full Answer >>
  3. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  4. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>
  5. What does high working capital say about a company's financial prospects?

    If a company has high working capital, it has more than enough liquid funds to meet its short-term obligations. Working capital, ... Read Full Answer >>
  6. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center