What is the acid test ratio?
The acid test ratio is a financial metric that measures a company's liquidity. It is also known as the quick ratio or the liquid ratio. The acid test ratio compares the value of the company's current assets that can be quickly converted into cash, such as cash, marketable securities, and accounts receivable, to its current liabilities, such as accounts payable and short-term debt. The acid test ratio shows how well a company can meet its short-term financial compulsion without relying on its inventory or other less liquid assets. A higher acid test ratio indicates a stronger liquidity position and a lower risk of insolvency.
How to calculate the acid test ratio?
The acid-test ratio measures how well a company can pay its current liabilities with its most liquid assets. It usually includes cash and cash equivalents, short-term investments, such as marketable securities, and accounts receivable. However, accounts receivable may not be very liquid in some industries, such as construction, where it may take longer to collect them. In that case, accounts receivable should not be part of the acid-test ratio.Basically, the ideal acid test ratio is 1:1.
The formula is:
Acid Test = (Cash + A/R + Marketable Securities)/Current Liabilities
Where: A/R = Accounts receivable