The acid-test ratio, also known as the quick ratio measures the liquidity of a company by calculating how well current assets can cover current liabilities. The quick ratio uses only the most liquid current assets that can be converted to cash within 90 days or less.
All of the information necessary to calculate the acid-test ratio can be found on a company's balance sheet and includes the following:
Current assets or all assets that can be converted into cash within one year:
- Cash and cash equivalents
- Marketable securities
- Accounts receivable
Current liabilities or a company's debts or obligations that are due within one year:
- Short-term debt
- Accounts payables
- Accrued liabilities and other debts
- The acid-test ratio involves assessing a company's balance sheet to see whether it has enough funding on hand to cover its current debt.
- It is seen as more useful than the often-used current ratio since the acid-test excludes inventory, which can be hard to quickly liquidate.
- In the best-case scenario, a company should have a ratio of 1 or more, suggesting the company has enough cash to pay its bills.
- Too low a ratio can suggest a company is cash-strapped, but in some cases, it just means a company is dependent on inventory, like retailers.
- Too high a ratio could mean a company is sitting on cash, but in some cases, that's just industry-specific, like with some tech companies.
Calculating the Acid-Test Ratio
The quick ratio is calculated by totaling cash and equivalents, accounts receivables, and marketable investments, and dividing the total by current liabilities as shown below:
Ideally, companies should have a ratio of a 1.0 or greater, meaning the company has enough current assets to cover their short-term debt obligations or bills. The acid-test ratio can be impacted by other factors such as how long it takes a company to collect its accounts receivables, the timing of asset purchases, and how bad-debt allowances are managed. Certain tech companies may have high acid-test ratios, which is not necessarily a negative, but instead indicates that they have a great deal of cash on hand.
The acid-test ratio is a more conservative measure of liquidity because it doesn't include all of the items used in the current ratio, also known as the working capital ratio.
The current ratio measures a company's ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The acid-test ratio is more conservative than the current ratio because it doesn't include inventory, which may take longer to liquidate.
The minimum acid-test ratio a company should have. Firms with a ratio of less than 1 are short on liquid assets to pay their current debt obligations or bills and should, therefore, be treated with caution.
The Bottom Line
No single ratio will suffice in every circumstance when analyzing a company's financial statements. It's important to include multiple ratios in your analysis and compare each ratio with companies in the same industry.