Acid-Test Ratio

Liquidity ratios Print Email

The term “Acid-test ratio” is also known as quick ratio. The most basic definition of acid-test ratio is that, “it measures current (short term) liquidity and position of the company”. To do the analysis accountants weight current assets of the company against the current liabilities which result in the ratio that highlights the liquidity of the company.

The formula for the acid-test ratio is:

Quick ratio = (Current Assets – Inventory) / Current liabilities

This concept is important as if the company’s financial statements ( income statement, balance sheet) get through the analysis of the acid-test ratio, then the short term debts can be paid by the company.

Example:

Let us suppose that XYZ Company has total \$2 million in its bank account and cash. The amount of accounts receivable (short term debitors of the XYZ company) is \$11 million. The amount of short term investments is \$4 million. The amount of Current liabilities (short term credit owed to others) is \$12 million. So the Acid-Test ratio of Company X is (2million +11 million + 4 million ) / (12 mill) = 1. 42.

If the value of the acid-term ratio is less than 1, then it is said that such a company is not stable and may face difficulty is paying off their debts (short term). In order to clear the short term debts they probably would need to sell some of their assets. But such an option affects the overall position of the company because if the company owns very little assets.

The biggest advantage of acid-test ratio is that it helps the company in understanding the end results very feasibly. The only major issue with the acid-test ratio is its dependence of the accounts receivable and current liabilities which can cause trouble. If due to any dispute the contract with the creditor or debtors gets messed up whole of the process gets unbalanced. And also, a minor mistake in the calculation can just destroy and conclude misleading outcomes.

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Quote Vic., 24 November, 2012
I am a little confused here. In your example, where you say "The amount of accounts receivable (short term creditors of the XYZ company) is \$11 million". Did you mean accounts payable then and not receivable cos receivable is what is owed to XYZ at a later date therefore it must be debtors of XYZ company I also feel if you included some inventory figure in your example to deduct as in the formula it would be simpler and straight forward?

Please clarify if i am wrong, i am student myself so you're response would be helpful.
Quote , 27 November, 2012
Quote
"The amount of accounts receivable (short term creditors of the XYZ company) is \$11 million"
It's misprint. "Creditors" changed to "debitors".
Quote Guest, 15 January, 2013
is prepaid expenses included in the computation of quick ratios?
Quote Guest, 28 February, 2013
what wil be the inventory in cas eof bank or financial institutuins.
Quote Guest, 3 April, 2013
Prepaid expenses is our long term assets so it can"t included in quike assets.
Acid test ratio ignore our current assets like inventory. It is possible to convert inventory into cash in a year.

Quote Guest, 9 May, 2013
I think the example is correct, Accounts Receivables are those poepole who owe XYZ Company and in their books they are captured as Debtors. Remember on the other hand Accounts Payables would be those that XYZ Company owe and they are captured as Creditors. So the example is fine as it is.

On the question of Inventory, the Quick Asset Ratio excludes the Invetory deliberatly because much as they are assets their conversion to cash is not determined by XYZ in the short term remeber Debtors have already committed a Sale its only collection.

On the Issue of Pre-Payments in my view these are current assets and should be included in the formula of cash, the rational being that its money paid before time and if it had not been paid it would be included in the formula as cash.
Quote Anand Tanna, 14 October, 2013
With this example if here in this question, if we had Inventory amount also then just simply we have to subtract it from \$2mn + \$11mn +\$4mn - Inventory / Current Liabilities.
am i right?
Quote Guest, 15 November, 2013
yes you are right
Quote Guest, 16 January, 2014
yes
Quote LT, 1 March, 2014
when adding your quick assets, I think you did your math wrong because the 17 million in quick assets divided by the 12 million in current liabilities should equal 1.42 not 1.33. And even when I work backwards and multiply 12 times 1.33 I still only get 15.96. Is there something I missing by any chance?
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