Loading the player...

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. 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

The acid-test ratio is commonly known as the quick ratio.

BREAKING DOWN 'Acid-Test Ratio'

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, such as, marketable securities. Accounts receivable are generally included, but this is not always appropriate. In the construction industry, for example, accounts receivable may take a long time to recover, therefore, its 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.

Interpreting the Acid-Test Ratio

Companies with an acid-test ratio of less than 1 do not have enough 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. For the fiscal year ended January 2017, Wal-Mart Stores Inc.'s acid-test ratio is 0.22, while Target Corp.'s is 0.29. The companies' current ratios are 0.86 and 0.94, 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.

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 balance sheet for the fiscal year ended September 30, 2017, showing the components of the company's current assets and current liabilities (all figures in millions of dollars):

     Cash and cash equivalents 20,289
     Short-term marketable securities 53,892
     Accounts receivable 17,874
     Inventories 4,855
     Vendor non-trade receivables 17,799
     Other current assets 13,936
          Total current assets 128,645
     Accounts payable 49,049
     Accrued expenses 25,744
     Deferred revenue 7,548
     Commercial paper 11,977
     Current portion of long-term debt 6,496
          Total current liabilities 100,814

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 = (20,289 + 53,892 + 17,874 + 17,799) / 100,814 = 1.09

Not everyone calculates this ratio the same. Reuters, for example, reports a quick ratio of 1.23 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.

RELATED TERMS
  1. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ...
  2. Accounting Ratio

    Accounting ratios, also known as financial ratios, are used to ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value ...
  4. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term ...
  5. Liquidity Ratios

    Liquidity ratios are a class of financial metrics used to determine ...
  6. Key Ratio

    Key ratios are the main mathematical ratios that illustrate and ...
Related Articles
  1. Investing

    Liquidity Measurement Ratios

    Learn about the current ratio, quick ratio, cash ratio and cash conversion cycle.
  2. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  3. Investing

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  4. Investing

    Debt Ratios

    Learn about the debt ratio, debt-equity ratio, capitalization ratio, interest coverage ratio and the cash flow to debt ratio.
  5. Investing

    Key Financial Ratios to Analyze Tech Companies

    Understand the technology industry and the companies that operate in it. Learn about the key financial ratios used to analyze tech companies.
  6. Investing

    Sysco and Other Big Movers In Services

    The market has been slipping so far today. The Nasdaq has fallen 0.3%; the S&P 500 has fallen 0.4%; and the Dow has declined 0.5%. The Services sector (IYC) is currently lagging behind the overall ...
  7. Investing

    SXC Health Solutions Corp. (USA) Among the Nasdaq's Biggest Movers

    The market is having a bad day so far: the Nasdaq is trading down 0.3%; the S&P 500 has declined 0.4%; and the Dow has slipped 0.5%. The Nasdaq Composite Index is a capitalization-weighted index, ...
  8. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  9. Investing

    Payout Ratio vs. Retention Ratio: When to Use Which

    The payback ratio and retention ratio collect different information and are useful in different situations.
  10. Investing

    What Is the Best Measure of a Company's Financial Health?

    Discover the single best financial metric that investors can use for determining the financial health and long-term sustainability of a company.
RELATED FAQS
  1. How is the acid test ratio calculated?

    The acid-test ratio, also known as the quick ratio, measures the liquidity of a company and is a more conservative measurement ... Read Answer >>
  2. Why do shareholders need financial statements?

    Discover the importance of a company's financial statements for stock shareholders in evaluating their equity investment ... Read Answer >>
  3. What is considered a good working capital ratio?

    Learn about the working capital ratio, a basic liquidity measurement for representing the current relationship between a ... Read Answer >>
  4. What do efficiency ratios measure?

    Learn about efficiency ratios, what they measure, how to calculate commonly used efficiency ratios and how to interpret these ... Read Answer >>
Trading Center