What’s it: The acid test ratio is a liquidity ratio to measure whether a company has sufficient cash to cover current liabilities using its liquid assets. First, we add up cash and cash equivalents, short-term investments, and accounts receivable to calculate it. Then, we divide the result by current liabilities. We also call this ratio the quick ratio.
The higher the acid test ratio, the better the company’s liquidity. That shows us it has enough liquid funds to pay its short-term bills without liquidating inventory or taking on external financing.
How to calculate the acid test ratio?
The acid test ratio shows how well a company can meet its short-term liabilities using relatively more liquid assets, such as cash and cash equivalents, short-term investments, and accounts receivable.
To calculate it, we exclude less liquid items or do not generate future cash inflows. Two examples are inventories and prepaid expenses.
Now take inventory as an example. Companies usually cannot convert inventory to cash quickly. It requires a long process and time. First, the company must convert raw materials into the final product. Then, they have to sell it.
Furthermore, the company may not convert those sales directly into cash. Some may become accounts receivable because customers purchased them on credit. Thus, to collect money from its entire investment in inventory, the company must also collect accounts receivable from customers. And, some customers may default on their payments due to financial difficulties, giving rise to bad debts.
For such reasons, we exclude inventories when calculating the acid test ratio.
Next, the calculation also excludes prepaid expenses. The company cannot convert them into cash in the future. It simply represents an inflow of economic benefits to the company in the future from paying suppliers upfront. Thus, when it appears on the financial statements, it does not contribute to cash inflows.
What is the formula for the acid test ratio?
Calculating the acid test ratio is relatively easy. We only need to add the liquid assets on the balance sheet in the current assets section, including cash and cash equivalents, short-term investments, and accounts receivable. We use their summation as the numerator.
Meanwhile, as the denominator, we use current liabilities. Here is the acid test ratio formula:
- Acid test ratio = (Cash and cash equivalents + Short-term investment + Accounts receivable) / Current liabilities
Some people may take a slightly different approach when calculating. They may start with total current assets and then subtract inventory. They might use the formula below:
- Acid test ratio = (Current assets – Inventories)/ Current liabilities
But nevertheless, we must be careful to use the latter formula. As I previously explained, some companies may report prepaid expenses and prepaid taxes on their current assets. These accounts do not generate cash inflows in the short term. Both represent only future benefits without involving cash inflows. So, since we calculate how much the company’s current assets cover current liabilities, including them doesn’t make sense.
Now, let’s take a simple example. A company reports the following information on its balance sheet:
- Cash and cash equivalents $100
- Marketable securities $400
- Accounts receivable $800
- Inventories $3,000
- Current liabilities $1,000
From these data, we calculate the acid test ratio, which is 1.3x = ($100 + $400 + $800) / $1,000.
Single numbers like this example don’t tell us anything. Instead, we have to compare it with previous years’ numbers to evaluate whether the company’s liquidity improves (ratio increases) or worsens (ratio decreases). In addition, to make more objective conclusions, we also need to compare them with peers or industry averages.
What is the difference between the acid test, current, and cash ratios?
The acid test ratio is more conservative than the current ratio. Both use the same formula, except for the denominator. The latter includes some less liquid items while the former does not.
However, the acid test ratio is less stringent than the cash ratio. The latter only uses the cash and cash equivalents as the numerator, excluding accounts receivable.
How to interpret the acid test ratio?
A higher acid test ratio indicates a better liquidity position. This is because the company has a high capacity to pay its short-term bills.
Several reasons explain the high ratio. The company manages operations effectively. So, it has faster inventory turnover and cash conversion cycles. Or, the company has effective accounts receivable collection policies and procedures, encouraging customers to pay on time.
Conversely, a lower ratio is less desirable. For example, if it is less than 1, the company does not have sufficient liquid assets to pay current liabilities. That could lead to liquidity problems. So, we need to examine the company’s finances more deeply about the causes.
Furthermore, suppose this ratio is much lower than the current ratio. In that case, the company is highly dependent on inventories to meet its current liabilities. That signals a liquidity problem because liquidating inventory into cash inflows takes a long time.
Several reasons explain why this ratio is low. For example, the company struggles to generate sales. Or the company has a less effective accounts receivable collection policy. Or, the company pays suppliers too quickly, for example, due to a weak bargaining position.
Special note
We usually include accounts receivable in the above calculations. However, it may not always be relevant for all companies. For example, companies in some industries, such as construction, have longer accounts receivable cycles.
Companies in such industries may have to convert accounts receivable for more than one year. In addition, the value is also significant.
Therefore, if we include accounts receivable in the calculations, it can make a company’s financial position appear much more secure than it really is. Thus, in this case, accounts receivable are excluded from calculating the acid test ratio because they are illiquid.
