What Is the Acid-Test Ratio?
The acid-test ratio, commonly known as the quick ratio, uses data from a firm's balance sheet to indicate whether it has the means to cover its short-term liabilities. Generally, a ratio of 1.0 or more indicates a company can pay its short-term obligations, while a ratio of less than 1.0 indicates it might struggle to pay them.
- The acid-test, or quick ratio, compares a company's most short-term assets to its most short-term liabilities to see if it has enough cash to pay its immediate liabilities, such as short-term debt.
- The acid-test ratio disregards current assets that are difficult to liquidate quickly, such as inventory.
- The acid-test ratio may not give a reliable picture of a firm's financial condition if the company has accounts receivable that take longer than usual to collect or current liabilities that are due but have no immediate payment needed.
What Is The Quick Ratio?
Understanding the Acid-Test Ratio
In certain situations, analysts prefer to use the acid-test ratio rather than the current ratio (also known as the working capital ratio) because the acid-test method ignores assets such as inventory, which may be difficult to liquidate quickly. The acid-test ratio is thus a more conservative metric.
Companies with an acid-test ratio of less than 1.0 do not have enough liquid assets to pay their current liabilities and should be treated cautiously. If the acid-test ratio is much lower than the current ratio, a company's current assets are highly dependent on inventory.
However, this is not a bad sign in all cases, 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. The acceptable range for an acid-test ratio will vary among different industries, and you'll find that comparisons are most meaningful when analyzing peer companies in the same industry as each other.
For most industries, the acid-test ratio should exceed 1.0. On the other hand, a high ratio is not always 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.
Calculating the Acid-Test Ratio
The numerator of the acid-test ratio can be defined in various ways, but the primary 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 appropriate for every industry. In the construction industry, for example, accounts receivable may take much more time to recover than is standard practice in other industries, so including it could make a firm's financial position seem much more secure than it is in reality.
The formula is:
Acid Test=Current LiabilitiesCash+Marketable Securities+A/Rwhere:A/R=Accounts receivable
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 because of the amount of inventory they carry. 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 ratio's denominator should include all current liabilities, debts, and obligations 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, it could be on much shakier ground than its ratio would indicate. The opposite can also be true.
Acid-Test Ratio 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 as of Jan. 27, 2022, showing the components of the company's current assets and current liabilities (all figures in millions of dollars):
|Cash and cash equivalents||37,119|
|Short-term marketable securities||26,794|
|Vendor non-trade receivables||35,040|
|Other current assets||18,112|
|Total current assets||153,154|
|Other current liabilities||49,167|
|Total current liabilities||147,574|
To obtain the company's liquid current assets, add:
- Cash and cash equivalents
- Short-term marketable securities
- Accounts receivable
- Vendor non-trade receivables
To get current liabilities, add:
- Accounts payable
- Other current assets
Then divide current liquid assets by current liabilities to calculate the acid-test ratio. The calculation would look like this:
Apple's ATR = ($37,119 + 26,795 + 30,213 + 35,040) / ($74,632 + $49,167) = 1.05
Not everyone calculates this ratio the same. There is no single, hard-and-fast method for determining a company's acid-test ratio. Some analysts might include other balance sheet line items not included in this example, and others might remove the ones used here. So, it is important to understand how data providers arrive at their conclusions before using the metrics given to you.
What's the Difference Between Current and Acid-Test Ratios?
Both the current ratio, also known as the working capital ratio, and the acid-test ratio measure a company's short-term ability to generate enough cash to pay off all debts should they become due at once. However, the acid-test ratio is considered more conservative than the current ratio because its calculation ignores items such as inventory, which may be difficult to liquidate quickly. Another key difference is that the acid-test ratio includes only assets that can be converted to cash within 90 days or less, while the current ratio includes those that can be converted to cash within one year.
What Does the Acid-Test Ratio Tell You?
The acid-test, or quick ratio, shows if a company has, or can get, enough cash to pay its immediate liabilities, such as short-term debt. For most industries, the acid-test ratio should exceed 1.0. If it's less than 1.0, then companies 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 a company's current assets are highly dependent on inventory. On the other hand, a very high ratio could indicate that accumulated cash is sitting idle rather than being reinvested, returned to shareholders, or otherwise put to productive use.
How to Calculate the Acid-Test Ratio?
To calculate the acid-test ratio of a company, divide a company’s current cash, marketable securities, and total accounts receivable by its current liabilities. This information can be found on the company’s balance sheet.
The Bottom Line
The acid-test ratio, also called the quick ratio, is a metric used to see if a company is positioned to sell assets within 90 days to meet immediate expenses. In general, analysts believe if the ratio is more than 1.0, a business can pay its immediate expenses. If it is less than 1.0, it cannot.
The reliability of this ratio depends on the industry the business you're evaluating operates in, so like many other financial ratios, it's best to use it when comparing similar companies.
Apple. "1/27/22 Apple Reports First Quarter Results," Page 2.