Accounting 101: Calculating And Understanding The Acid Test Ratio

The acid test ratio—also known as the quick ratio—is a financial ratio that is calculated by dividing the sum of a business’ cash and cash equivalents, marketable securities, and accounts receivable balances by the balance of all its current liabilities.



This ratio is also known as the quick ratio because its numerator consists of a business’ “quick” assets—that is, its assets that are most readily available to pay down debt. Cash is obviously immediately available, and, of all other current assets, marketable securities and accounts receivable are the next most readily available, in theory.



The acid test ratio is similar to the current ratio in that it is a test of a company’s short-term liquidity. However, the acid test ratio is more conservative because, while the current ratio includes all current assets (including inventory) in the numerator, the acid test ratio includes only cash and cash equivalents, marketable securities, and accounts receivable in the numerator.





How To Calculate Acid Test Ratio



You can calculate a business’ acid test ratio by looking at its balance sheet, identifying the combined balance of all its quick assets, and dividing this combined quick asset balance by the balance of all its current liabilities.



Here is the formula for the acid test ratio:



(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities = Acid Test Ratio







Acid Test Ratio Example



Let’s use the hypothetical balance sheet below to calculate the acid test ratio.



Assets Cash and Cash Equivalents $100,000 Accounts Receivable $200,000 Inventory $300,000 Property, Plant, and Equipment (PP&E) $1,000,000 Accumulated Depreciation on PP&E <$600,000> Total Assets $1,000,000 Liabilities & Owners’ Equity Accounts Payable $250,000 Accrued Salaries $10,000 Income Taxes Payable $25,000 Short-Term Loans Payable $15,000 Long-Term Debt $200,000 Owners’ Equity $500,000 Total Liabilities & Owners’ Equity $1,000,000



The first thing to do is identify the balance of all the business’ quick assets accounts and the balance of its current liabilities.



This business’ quick assets are cash and cash equivalents, which has a balance of $100,000, and accounts receivable, which has a balance of $200,000.  So the total quick assets in this example is $300,000.



The rest of the assets on the balance sheet are not quick assets and are therefore excluded from the acid test ratio.



The current liabilities on the example balance sheet are accounts payable, accrued salaries, income taxes payable, and short-term loans payable.  Combined, these liabilities total $300,000.



These liabilities are current liabilities because they are expected to be paid off within the next year.



Since this business’ quick assets total $300,000 and its current liabilities total $300,000, its acid test ratio is 1.0.








What Is A Good Acid Test Ratio?



At a minimum, a business should have an acid test ratio of at least 1.0.



Although not a guarantee, an acid test ratio of 1.0 or greater indicates that the business likely has enough readily available assets to pay down its short-term liabilities.



An acid test ratio of less than 1.0 could indicate that a business may be at risk of a liquidity crisis if it cannot convert its other current assets to cash as quickly as it has in the past, such as if its inventory becomes obsolete.



At the other extreme, an acid test ratio that is too high could indicate that a company is holding on too tightly to its cash when it could be using it to fuel business growth.



That said, like all financial ratios, the acid test ratio should be considered in line with industry averages.








Limitations Of The Acid Test Ratio



As with other business formulas , the acid test ratio is a quick way to assess one component of a business’ financial health—in this case, its short-term liquidity—but is not without its limitations.



For example, as is the case for any financial ratio based on the balance sheet, the acid test ratio is calculated as of a particular date; it does not consider historical trends or future transactions.  A business’ acid test ratio may increase or decrease significantly in the near future, so today’s acid test ratio should be interpreted with future impacts in mind.



A second limitation of the acid test ratio is that it counts all of a business’ accounts receivable—fresh and aged—against its current liabilities. Now, while some small businesses may collect all or nearly all of their accounts receivable, other businesses may not. If a business’ accounts receivable balance consists of a lot of 90- or 120-day receivables that will likely be written off eventually, the business’ acid test ratio may be misleadingly reassuring.







Information provided on this blog is for educational purposes only , and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strivers to keep its content up to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.



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