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 Acid-test ratio is a measure of a company's liquidity that is similar to the Cash Ratio. However, unlike the Cash Ratio, which only considers cash and cash equivalents, the Acid-test ratio also takes into account other highly liquid assets that can be quickly converted into cash. These assets include things like accounts receivable and short-term investments.
The formula for the acid-test ratio is:
Quick ratio = (Cash + Cash Equivalents + Short-term Investments + Accounts Receivable) / Current liabilities
Inventory is not included in the quick (acid-test) ratio calculation because it may be difficult for a company to convert all of its inventory into cash in a short period of time. Excluding inventory from the formula makes the quick ratio a better indicator of a company's ability to pay its current obligations than the current ratio, which includes inventory in its formula.
Prepaid expenses are typically not included in the quick ratio calculation due to the lack of liquidity.
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.
It's important to note that different companies may have different ways of calculating their quick ratios, and some may include certain items that others do not, depending on their industry and business operations. It's always best to check and compare the company's financial statements and footnotes to see how it calculates its quick ratio and other financial ratios.