Accounting ratios are metrics that allow stakeholders to calculate the relative magnitude of two selected values. These values come from a company’s financial statements, usually the balance sheet and income statement. Usually, stakeholders use various accounting ratios, which fall under several categories. For example, these may include liquidity, profitability, leverage, etc.

In most circumstances, accounting ratios come in a decimal value form. In some cases, stakeholders may also prefer a percentage value. Either way, they help understand the contrast between two financial statement items. Through these ratios, stakeholders can gain valuable insights into a company’s financial operations. In most cases, these ratios reveal statistics that the financial statements don’t.

Accounting ratios are highly crucial for understanding a company’s operations. These can also enable better comparisons between several companies. As mentioned, accounting ratios fall under several categories. The liquidity ratios are crucial in evaluating a company’s financial position in terms of liquidity. This category includes the acid test ratio, which can be highly critical. Before discussing this ratio, it is crucial to study liquidity ratios.

What are Liquidity Ratios?

Liquidity ratios are a category of accounting ratios that allow stakeholders to measure a company’s liquidity position. These ratios help them understand whether the underlying company can pay off its debts when they are due. Therefore, liquidity ratios consider working capital more than other statistics. With profitability ratios, liquidity ratios are one of the most favorite metrics for stakeholders.

Liquidity ratios help stakeholders understand the contrast between a company’s performance and obligations. More specifically, these ratios help reveal whether a company’s current assets can cover its current liabilities. By considering this relative magnitude, stakeholders can understand how the company fares in its daily operations. Moreover, it reveals critical information about its working capital management.

In most circumstances, liquidity ratios consider current assets and current liabilities. However, it may also require income statement items, for example, sales and purchases. These ratios reveal critical information about how the company manages its current assets to repay financial obligations. However, it may also assess its efficiency in managing its resources.

Stakeholders can use various liquidity ratios to assess a company’s liquidity position. Among these, the most prominent ones include the current ratio, acid-test ratio, and cash ratio. Some other liquidity ratios may also include accounts receivable to sales, accounts payable to purchases, receivable days, payable days, etc. Among the several stakeholders that companies may have, these ratios are favorite for creditors/lenders.

Overall, liquidity ratios reveal critical information about a company’s liquidity position. It considers whether a company has enough short-term resources to cover short-term debt obligations. In short, it looks at its current assets and current liabilities. One of these ratios includes the quick ratio, also known as the acid test ratio.

What is the Acid Test Ratio?

The acid test ratio, also known as the quick ratio, considers whether a company has enough short-term assets to cover its short-term obligations. It is similar to the current ratio, which shows the relative magnitude of a company’s current assets to current liabilities. However, the acid test ratio does not consider all current assets for this calculation. It takes out inventories from the figure before calculating the ratio.

The asset test ratio reveals critical information about a company’s immediate liquidity. Compared to working capital numbers, the acid test ratio is more accurate. As mentioned, it considers all current assets except inventories. This exclusion comes due to the challenges that companies may face in converting those stocks into cash. Therefore, the acid test ratio does not consider inventories to be liquid.

While liquidity ratios look at a company’s liquidity position as a whole, the acid test ratio only looks at short-term liquidity position. It measures a company’s ability to satisfy its short-term obligations with its most liquid assets. Compared to the current ratio, the quick ratio is more conservative due to its consideration of fewer assets. Usually, these assets include cash, accounts receivable, and marketable securities.

However, not all companies may have these assets. On top of that, considering the immediate liquidity of an asset may require judgment from stakeholders. Therefore, it is more straightforward to remove inventories from total current assets to calculate this ratio. Stakeholders can use both methods, although the former will provide more accurate results. However, it is crucial to use the same approach for all comparisons.

Overall, the acid test ratio considers the ratio between a company’s current assets minus inventories and current liabilities. This ratio measures its immediate or short-term liquidity position. In most circumstances, stakeholders prefer this ratio to be high, similar to the current ratio. However, the acid test ratio may be more conservative in comparison.

How to calculate the Acid Test Ratio?

Calculating the acid test ratio is straightforward. As mentioned, there are two methods to measure it. The first involves using the most liquid assets, namely, cash, accounts receivables, and marketable securities. Once stakeholders sum these figures, they must divide them by current liabilities to calculate this ratio. Therefore, the formula for the acid test ratio will be as follows.

Acid test ratio = (Cash and cash equivalents + Accounts receivables + Marketable securities) / Current liabilities

However, the alternative method to calculate the acid test ratio may be more straightforward. This method does not require any judgment to determine the liquidity of an item within current assets. The alternative approach involves deducting a company’s inventories from its current assets. After that, it requires the division of the residual amount by the current liabilities. Under this approach, the acid test ratio formula will be as follows.

Acid test ratio = (Current Assets – Inventories) / Current Liabilities

Both of these methods will provide an estimate of a company’s immediate liquidity position. However, stakeholders must use the same approach when using this ratio comparatively. In both situations, the denominator will remain the same.

What is a good Acid Test Ratio?

Stakeholders can use the acid test ratio comparatively to study a company’s immediate liquidity position. Unlike other accounting ratios, however, they can also use the acid test ratio on their own. Most stakeholders may wonder what a good acid test ratio is. The answer to this involves looking at various factors.

Generally, the higher a company’s acid test ratio is, the better stakeholders will consider it. Most experts recommend for companies maintain this ratio to be at least 1. This ratio implies the company has the same amount of liquid current assets to cover its short-term debts. However, in some industries, this ratio may be lower due to how they operate.

In general, a good acid test ratio lies at 1.0 or above it. However, it is more crucial to understand the industrial average before comparing this information. In some industries or sectors, this ratio may be lower without suggesting any adverse implications. Nonetheless, most experts believe an acid test ratio of below 1.0 to be unfavorable.

Overall, the context in which stakeholders view the acid test ratio is highly crucial. When used comparatively, they must aim for a higher figure. Between several companies, the company with this highest quick ratio will be favorable. However, understanding the average for the industry or competitors is also crucial in interpreting the acid test ratio.

Example

A company, ABC Co., has total current assets of $12 million. The company has total inventories of $4 million among these assets. In contrast, ABC Co.’s current liabilities equal $10 million. Therefore, its acid-test ratio will be as follows.

Acid test ratio = (Current Assets – Inventories) / Current Liabilities

Acid test ratio = ($12 million – $4 million) / $10 million

Acid test ratio = 0.8

Overall, ABC Co.’s acid test ratio of 0.8 falls below the recommended average. However, it is crucial to understand the context to which this ratio relates. If the industrial mean for the sector in which ABC Co. operates is lower, this ratio is better. Similarly, if its competitors have a similar or lower figure, ABC Co. may be above average.

Conclusion

Accounting ratios allow stakeholders to gain valuable insights into a company’s operations. Among these, liquidity ratios consider the ability to repay debts when they arise using short-term assets. The acid test ratio measures the immediate liquidity position of a company. In most circumstances, a good acid test ratio will be 1.0 or above it.