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.
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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- Cash Flow Indicator Ratios
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