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 include the following:
Current assets or all assets that can be converted into cash within one year:
Current liabilities or a company's debts or obligations that are due within one year:
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 at 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.
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. 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 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.