Acid-Test Ratio

Liquidity ratios Print Email

The term “Acid-test ratio” is also known as quick ratio. The acid-test ratio is basically used for evaluating whether a company has adequate liquid assets that can be instantly converted into cash to pay the company’s short-term liabilities. In order to calculate the asset-test ratio one should divide the company’s liquid current assets by its current liabilities.

The formula for the acid-test ratio is:

Quick ratio = (Cash + Accounts receivable + Marketable securities) / Current liabilities

Inventory is not included in the calculation of the asset-test ratio as it can be quite difficult for a business to convert all its inventory into cash within a short period of time. The exclusion of inventory from the formula makes the quick ratio a better indicator of a company’s ability to pay-off its current obligations than the current ratio which does include inventory in its formula.

Example:

Let us suppose that XYZ Company has cash and cash equivalent of $2 million. The company has   accounts receivable (credit given to customers for a short period of time) of $11 million and has made short term investments of $4 million. The amount of Current liabilities (short term credit owed to others) of the company is $12 million. The Acid-Test ratio of the Company XYZ is (2million +11 million + 4 million) / (12 mill) = 1.42.

If the value of the acid-test ratio is less than 1, then it indicates that a company does not have adequate assets that can instantly be liquidated by the company to pay off all its current liabilities. In such a situation the company would probably be required to sell some of its other long-term assets to settle its short-term liabilities.

The best advantage of acid-test ratio that it is very simple to understand and straight forward as well. It helps the users of the financial statements and the ratio who doesn’t have in-depth knowledge about accounting and finance to understand this ratio easily.  Another advantage of acid-test ratio is that it helps in measuring how well a company’s current assets pay-off its current liabilities more accurately when compared with other liquidity ratios especially the current ratio.

The biggest disadvantage of the acid-test ratio is that it is heavily dependent on accounts receivable and current liabilities which could be influenced by the company’s management if they want. Acid-test ratio is basically financial indicator which can be influenced by the company’s management through fictitious financial information or change in accounting policies.

The only major issue with the acid-test ratio is its dependence on the accounts receivable and current liabilities which can cause trouble. If due to any dispute the contract with the creditors 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 Vit. A., 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.

please give me suggestion.
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?
please lemme know
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?

[Admin: Thanks! Corrected.]
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