The quick ratio uses only the most liquid current assets that can be converted to cash within 90 days or less.
- The acid test, or quick 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.
What Is The Quick Ratio?
What You Need to Calculate the Acid-Test Ratio
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
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:
Interpreting the Acid Test Ratio
Ideally, companies should have a ratio of 1.0 or greater, meaning the firm has enough liquid assets to cover all 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, for instance, 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.
Because the acid test is a quick and dirty calculation, other ratios that include more balance sheet items, such as the current ratio, should be evaluated as a more comprehensive check on liquidity if the acid test appears to fail.
Consider Tesla Motors (TSLA) balance sheet for the fiscal year ended 2020.
The information we need includes Tesla's 2020 cash & cash equivalents, receivables, and short-term investments in the numerator; and total current liabilities in the denominator.
Cash & equivalents total $14.35 billion + $1.75 billion in receivables = $16.1 billion (there are no short-term investments listed). Current liabilities total $13.3 billion.
The acid test ratio for TSLA in 2020 is therefore $16.1 / 13.3 = 1.21.
This value is over 1.0, indicating that Tesla has decent liquidity and should be able to cover its short-term obligations.
What Is the Difference Between Current Ratio and Acid-Test Ratio?
The acid-test or quick ratio only includes the most liquid current assets in the numerator. The current ratio instead uses total current assets, which includes additional items such as inventories that may not be as liquid.
What Does the Acid Test Tell You?
The acid test provides a back-of-the-envelope calculation to see if a company is liquid enough to meet its short-term obligations. In the worst case, the company could conceivably use all of its liquid assets to do so. Therefore, a ratio greater than 1.0 is a positive signal, while a reading below 1.0 can signal trouble ahead.
What Is the Difference Between Liquidity and Solvency?
Liquidity corresponds with a company's ability to immediately fulfill short-term obligations. Ratios like the acid test and current ratio help determine a firm's liquidity. Solvency, although related, refers to a company's ability to instead meet its long-term debts and other such obligations. A company may be illiquid but solvent, for example, or vice-versa.
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.