Acid-test ratio
The Acid test - ratio or Quick ratio also called the acid test ratio, compares current assets and current liabilities similarly to the current ratio. The quick ratio removes inventory because it is typically the least liquid asset for a corporation and losses typically arise when selling such assets, which is the primary distinction between these two ratios. Short-term prepayments made by the business are also not included in this computation[1]. Given that inventory have been removed from this calculation because they may not be immediately realizable, the quick ratio measures the company's liquidity more strictly than the current ratio.
Quick ratio
The quick ratio calculates how much current assets are compared to current liabilities. We can argue that the liquidity is good if the current assets can meet the current liabilities. The more crucial liquidity a company has, the lower its current assets to current liabilities ratio.
Alternate formula [2]:
- Quick assets refer to current assets less inventory & Short Term Prepayments.
- Current assets refer to cash and cash equivalents, Marketable securities and accounts receivable.
- Current liabilities refer to Accounts payable, short term debts and other short-term liabilities.
Quick ratio guidelines
Table 1. Quick ratio Indicator Table
| Quick ratio | Valuation |
|---|---|
| Over 1 | good |
| 0.5-1 | Satisfying |
| Under 0.1 | Weak |
The acid-test ratio, is a numerical indicator of a company's capacity to pay short-term obligations by selling off its assets. It is computed by dividing current liabilities by the total of all assets less inventories. A ratio score of one or higher is typically regarded as favorable because it suggests that the company can meet its short-term liabilities [3]. A company is penalized if its ACID-test ratio is less than one since it means that it will be unable to pay its debts because there are fewer assets than liabilities. However, a very high acid-test ratio can also indicate that there is cash or unused inventory on the balance sheet. These ratings aren't uniform across industries, though. Depending on the business environment and the industry, acid-test ratios can be favorable or harmful. For instance, a retail giant like Walmart might be able to work out favorable payment terms with vendors who don't need immediate payment. These words will be converted to liabilities and additional inventory on the balance sheet. The ratio's denominator will be larger for the quick ratio. As a result, the business can have a low rating and unused inventory. However, such need not be detrimental to its business. Another example is the low fixed inventory quantities of technology companies. They also generate healthy profits that might not always be invested back into the company because of their high margins. One example is Apple, which, under former CEO Steve Jobs, had significant cash available. Under Jobs, its quick ratio almost reached 3. It was still regarded as a desirable investment, though. Since the business started paying dividends to investors, its quick ratio has largely steadied at typical levels of about 1.
Analysis for Quick Ratio
Quick ratio can be a useful tool for determining a company's ability to meet its short-term obligations. However, it's crucial to keep in mind that they only serve as a rapid analytical tool in a certain context and do not accurately reflect the state of a firm's financial obligations. The company's debt obligations can be evaluated more accurately with a cash flow budget. Although ratios of one or more are regarded as healthy for quick ratios,they can differ depending on the sector. Since the retail sector often holds more inventory than other sectors, as was already said, acid-test ratios for this sector tend to be lower than usual. The amount of inventory held might vary depending on the size of the business, even within the retail sector. For example, large retailers like Walmart, Target, and Costco are able to negotiate advantageous supplier terms that do not compel them to pay their vendors right away or in accordance with industry standards. As a result, their quick ratios may be below average and their balance sheet inventory statistics may be excessive. Compared to small shops, who need to move product as rapidly as possible to produce cash flow to operate their business, this position is similar. Acid-test ratios at these stores will be close to or equal to one.
Importance of Acid Test Ratio
Acid-test ratios are a quick indicator of a company's ability to survive and a function of how quickly it can produce cash under pressure. The current ratio is a different ratio that assesses the liquidity of an organization. However, regardless of duration or maturity date, it considers all current assets and liabilities. As a result, it is not a particularly useful statistic for determining whether the business can survive if and when its creditors make a claim. The quick ratio sets a deadline and limits the amount of assets that can be considered in calculations.
Improvements Companies might take action to raise their asset count or decrease their liabilities in order to improve their fast ratios. For instance, they could relocate inventory to decrease the effect it has on the ratio as a whole. Another tactic is to invoice pending orders and goods so that they can be added to current assets as accounts receivables in accounting books. In a similar vein, firm expenditures that may have increased liabilities and account payable numbers can be postponed to the following quarter or fiscal year to improve quick ratios.
Examples of Acid-test ratio
- Acid-test ratio is a metric used to measure a company's short-term liquidity. It is calculated by dividing a company's total current assets (such as cash and cash equivalents, marketable securities, and accounts receivable) by its total current liabilities (such as accounts payable, accrued expenses, and short-term debt). In other words, the acid-test ratio is a measure of a company's ability to pay off its short-term debts and obligations without relying on the sale of inventory.
- A company with a higher acid-test ratio is considered to be more financially sound and less likely to default on its obligations. For example, if a company has $100,000 in current assets and $50,000 in current liabilities, its acid-test ratio would be 2.0, indicating that it has twice as many current assets as current liabilities and is in a strong financial position.
- As a reference, the general rule of thumb is that a company should maintain an acid-test ratio of at least 1.0, meaning it has at least as many current assets as current liabilities. A company with an acid-test ratio below 1.0 may be in danger of defaulting on its short-term obligations.
Advantages of Acid-test ratio
The Acid-test ratio has many advantages, including:
- The ability to provide an indication of a company's liquidity, or ability to pay its short-term obligations.
- It eliminates inventory from the calculation, which can be a source of inaccurate results if it is not up-to-date or reported correctly.
- It is also able to detect companies that are using aggressive accounting methods to artificially inflate their current assets.
- It is an excellent tool for comparative analysis, as it is able to compare the liquidity of two companies in the same industry.
- It is a valuable indicator for creditors and investors, as it reveals the company's ability to pay its debts in a timely manner.
Limitations of Acid-test ratio
The Acid-test ratio has several limitations, including:
- It does not take into account the liquidity of other assets such as debtors or receivables, which could be converted into cash in the near future.
- It also does not take into account any potential future liabilities, such as taxes or other long-term debt payments.
- It does not account for the company’s ability to generate future funds from operations.
- It does not consider the company’s ability to borrow money from lenders or investors if needed.
- It ignores the impact of sales of inventory on liquidity.
- It does not take into account the time sensitivity of the current assets and liabilities.
- It doesn't consider the company’s overall financial strength, as it only looks at a snapshot of the company’s current financial position.
The acid-test ratio is commonly used to measure a company's liquidity and financial strength. There are several other approaches related to the acid-test ratio including:
- Cash Ratio: This ratio is similar to the acid-test ratio, but only includes cash and cash equivalents (such as marketable securities) as current assets.
- Debt Service Coverage Ratio (DSCR): This ratio compares a company's cash flow to its debt service payments. It helps lenders and investors measure a company's ability to pay its debts.
- Liquidity Ratio: This ratio measures a company's ability to meet its short-term obligations such as repaying debt. It is calculated by dividing current assets by current liabilities.
In summary, the acid-test ratio is a measure of a company's liquidity and financial strength. There are several other approaches related to the acid-test ratio that measure a company's ability to pay its debts and meet its short-term obligations.
Footnotes
| Acid-test ratio — recommended articles |
| Asset coverage ratio — Solvency ratios — Debt to total assets ratio — Average collection period — Capital gearing — Return on sales — Average payment period — Debt management ratio — Payables turnover — Free float |
References
- Lohrey, J. (2018), Importance of Ratio Analysis in Financial Planning, Chron: Financial ratios
- Mohammed, N. (2014), HorJournal of Educational and Social Research: Role of Ratio Analysis in Business Decisions, Mcser Publishing, Vol. 4 - No.5
- Noor, A., & Lodhi, S., (2015), Impact of Liquidity Ratio on Profitability: An Empirical Study of Automobile Sector in Karachi, International Journal of Scientific and Research Publications, Volume 5 - Issue 11
Author: Billa Nalini
