A measure of a business's ability to employ short-term assets to cover its current liabilities.
Acid-Test Ratio Details
The acid-test ratio (which is sometimes called the quick ratio) compares short-term assets with short-term liabilities to see if a company has enough cash on hand to cover payments due. The acid-test counts the cash and accounts receivable as positive factors and immediate liabilities as negative factors. It does not include inventory on the assumption that inventory can be difficult to change into cash quickly.
The acid-test ratio is liquid assets (cash plus accounts receivable) minus current liabilities. If your results give you a ratio of 1:1, the business has precisely the cash it needs to cover its immediate debts. If the ratio ends up 2:1, the business has twice the amount of cash on hand to cover its immediate debts. However, If the ratio is 1:2, then the business has only half of the cash it needs to cover the debts that it needs to pay in the immediate future.
The great advantage of the acid-test ratio is that it is a quick and easy method of obtaining a snapshot of a company's current position, but there are questions about its validity. The acid-test ratio makes two assumptions which, depending on a company's situation, may be doubtful. Firstly, the assumption that inventory cannot be counted as an asset because it is difficult to convert into cash is not always the case. Some businesses can easily and quickly sell inventory and boost their cash on hand. Secondly, considering accounts receivable as a liquid asset is fine, but only if the business owner is certain that they can settle those accounts before debts fall due.
Acid-Test Ratio Example
Shirley runs a small bar and restaurant, which she has had to close for a month due to illness. At the end of the current month, she has bills to pay. She counts the cash that she has available and adds the money that customers owe her. She discovers that the amount she has available is $4,500 but the bills that she must settle come to $5,200. Shirley's business has a negative acid test ratio, and she worries that this will negatively affect her business standing. However, she decides to quickly convert some of her inventory into necessary cash by offering customers discounts and special offers. She raises the cash required to meet her obligations and avoids friction with unpaid suppliers, staff, and bank charges. For Shirley, the acid-test ratio has acted as a warning that she needed to do something quickly but was not definitive.
Acid-Test Ratio vs. Current Ratio
The acid-test ratio is a simplified version of the current ratio. The current ratio also measures the present financial health of a business but differs from the acid-test ratio in that it includes inventory as an asset. Therefore, the current ratio is more difficult to calculate but probably offers a more accurate picture of the financial picture than does the acid-test ratio.