Is a high acid-test ratio good?

By Indeed Editorial TeamUpdated September 9, 2021 | Published February 4, 2020Updated September 9, 2021Published February 4, 2020An acid-test ratio, also referred to as a quick rat

Is a high acid-test ratio good?

By Indeed Editorial Team

Updated September 9, 2021 | Published February 4, 2020

Updated September 9, 2021

Published February 4, 2020

An acid-test ratio, also referred to as a quick ratio, is a number thats used to determine whether a company has enough current assets to pay its short-term liabilities. One way to estimate a company's immediate liquidity is to refer to the company's most recent balance sheet and use the figures to calculate an acid-test ratio. In this article, we explain what the acid-test ratio is, how it is calculated, how to interpret the results and we include an example.

What is the acid test ratio?

By looking at figures from their current balance sheet and calculating the acid-test ratio, a company can determine its immediate liquidityor their ability to pay their short-term liabilities.

The acid-test ratio is often more accurate than working capital numbers, as it shows only the assets that can be converted into cash within one quarter, excluding all other assets, such as inventory.

To determine your companys acid-test ratio, consult the following from your company's current balance sheet:

  • Cash and cash equivalents: These are the assets considered most liquid and could include actual cash in bank accounts, short-term deposits (maturing in less than three months) and treasury bills.
  • Marketable securities: These are technically debts, but they're able to be converted to cash quickly and include items such as certificates of deposit, government bonds and common stock.
  • Accounts receivables: These are outstanding invoices, or money owed from customers.
  • Current liabilities. The company's short-term debts (those due within one year.)

Related: Learn About Being a Finance Manager

How to calculate the acid test ratio

The acid-test ratio can be calculated using the following formula:

(cash + short term investments + current receivables) / current liabilities = acid test ratio

1. Add cash + short term investments + current receivables

Cash also includes easily liquidated assets. Accounts receivables are sometimes included with current receivables, depending on the industry of the company. For example, construction companies might exclude accounts receivables because it may take longer to collect than in other industries. This is important to consider because these figures can make the company seem more financially secure than it really is.

Assets that cannot be considered in determining short-term liquidity should be subtracted from the total current assets. For example, the liquidity of inventory on hand is unpredictable and shouldn't be considered a liquid asset or as part of the acid-test ratio calculation.

Other assets that should be left out of this calculation might include prepayments, deferred tax assets and advances to suppliers, as they can skew the actual liquidity of the company.

2. Divide the sum from step 1 by current liabilities

This formula should include all liabilities that are due in a year or sooner. No other liabilities should be included in this formula as it would give you an inaccurate result. Once you have divided the sum from step 1 by all of your current liabilities, you will have your acid-test ratio.

One final note: time is not considered in the calculation of this ratio. This is important because if the company has payables due soon, but its receivables won't be recovered for several months, the acid-test ratio could deceptively omit the financial troubles the company could be facing in the short-term.

The opposite can be true, as well. If the company's receivables come in all at once and the payables aren't due for a while, the company could look deceptively solid.

Related: CFA Exam: How To Advance Your Financial Career

What do the results of the acid test ratio mean?

The figure provided by the acid-test ratio is a conservative estimate of a company's ability to pay its current liabilities without seeking to obtain additional funding. The company's financial health is determined by this quick ratio, with a higher number indicating more liquidity and a lower number (less than one) implying impending financial troubles.

For example, if a company's acid-test ratio is 2, the figure indicates that the company has twice the dollar value of liquid assets than current liabilities. So, if the current liabilities are $100,000 and the acid-test ratio is 2, that would put the liquid assets at $200,000. This ratio is indicative of good financial health.

It is important to keep in mind that an excessively high ratio can imply that the company isn't using its resources wisely. For instance, too much extra cash means it's not being invested into growing the business, while a disproportionate accounts receivable figure can indicate that the company isn't doing a good job of collecting what's owed to it.

On the other hand, companies with a low acid-test ratio (less than 1) are considered to have insufficient access to liquid assets for purposes of paying their current liabilities. The company could be facing financial troubles. A low acid-test ratio isn't necessarily bad in all cases, though.

For example, a retail chain store is dependent on moving inventory, so they might have a low acid-test ratio. Since the acid-test ratio is just an estimate, it only considers the short-term health of the business.

Related: What Is a Financial Ratio? (Definition, Types and Examples)

Faqs about acid-test ratios

Here are answers to frequently asked questions about acid-test ratios:

Is there an ideal acid-test ratio result?

There is no universally ideal ratio number or range that applies to every industry, but generally, the ratio should be larger than one. The optimal number will fluctuate depending on the industry, the market and the size and financial stability of the company.

The acid-test ratio may hold little significance for an established business of a certain size as the business may operate on long-term revenue terms or have an excellent credit standing, allowing for short-term funding to be accessed, if needed.

Are there any drawbacks to using the acid-test ratio?

While there are many advantages to using the acid-test ratio, there are also some potential drawbacks, including:

  • The acid-test ratio typically considers accounts receivable an easily liquidated asset, but that may not always be true.
  • This method is often not enough on its own to accurately calculate the overall financial position of a company, so companies will pair it with another methodsuch as current or cash flow ratiosto get a more accurate overall picture of the company's finances.
  • The ratio does not consider inventory on hand in the calculation due to the assumption that inventory is not a liquid asset. In some industries, however, inventory can be quickly converted to cash at fair market value.
  • This ratio does not consider time, which can be an important factor when estimating the company's ability to pay its debts when they come due.

Related: Learn About Being a Financial Analyst

Acid test ratio example

The acid-test ratio is calculated using the figures from the company's balance sheet for the desired period. Here is an example of a balance sheet acid-test ratio calculation:BALANCE SHEET AS OF SEPTEMBER 30, 2019
Cash and cash equivalents$25,912Accounts payable$55,988Short-term marketable securities$40,385Long-term debt$93,740Accounts receivable$23,191Total current liabilities$149,728Inventories$3,957Other receivables$25,808Other current assets$12,086Total current assets$131,339Total current liabilities$149,728

Read more: What Is Quick Ratio?

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