Businesspeople who do not come from a strong financial background are often overwhelmed by the various financial ratios used to assess the health of a company. A quick and easy way of assessing whether a company has sufficient short-term assets to cover its short-term liabilities is to work out the acid test ratio.
Refresher:
- A ratio is a comparison of the size of one number against the size of another number. A ratio of 1:1 indicates the two numbers are equal. A ratio of 1:2 indicates that the second number is twice the size of the first number.
- A short-term asset is an asset that can be sold, converted into cash, or liquidated to pay for liabilities within one year.
- A short-term liability is a debt that is expected to be paid off within one year.
About the Acid-Test Ratio
- The acid-test helps you to see if a company has enough cash to pay its immediate liabilities, such as short-term debt.
- The acid-test ratio ignores those current assets that are difficult to quickly turn into cash, such as inventory.
- The acid-test ratio may not give a reliable picture of a firm’s financial condition if the company has debtors accounts that take longer than usual to collect or current liabilities that are due but have no immediate payment needed.
- The acid test is useful when you are assessing a customer’s ability to pay your accounts on time.
- The name of the acid-test ratio is derived from the historic use of acid to test metals for gold. If acid was applied to a metal and didn’t corrode it, that meant that the metal was real gold. However, if the metal failed the test, it was considered valueless. It is also known as the quick ratio.
- The acid test is one of the more common business ratios used by financial analysts.
Understanding the Acid-Test Ratio
The ac id test provides a worst-case understanding of the financial situation of a business. By ignoring the value tied up in inventory it is thus a conservative metric. Like all one-number evaluations, it must be interpreted within the context of the business, its lifecycle, the market and its industry. The acid test is the first ratio to look at when analysing a company’s financial situation. From there, other questions may arise.
Companies with an acid-test ratio of less than 1 do not have enough liquid assets to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that a company’s current assets are highly dependent on inventory.
The acid test ratio measures how quickly a company’s assets can be turned into cash. The acid test is a highly reliable indicator of a company’s financial strength and its ability to meet its short-term obligations. Because inventory can sometimes be difficult to liquidate, the asset test ratio deducts inventory from current assets before they are compared with current liability.
Potential creditors like to use the acid test ratio because it reveals how a company would fare if it had to pay off its bills under the worst possible conditions. (Creditors are people or companies who are owed money.) The assumption behind the acid test ratio is what is the situation when people who are owed money start demanding immediate payment and there is no time to sell inventory to generate cash.
The acid test ratio formula is generally expressed as:
(current assets less inventory) / current liabilities = acid test ratio
Here is an example:
Current assets = R 7700
Current inventory = R 1200
Current liabilities = R 4500
These figures are drawn directly from the balance sheet of the company. They have standard accounting definitions and methods of calculation.
The calculation of the acid test ratio in our example is as follows:
( 7700 – 1200 ) / 4500 = 1.44
This means that for every R1 of debt, the company has R1.44 of asset.
How to use the acid test ratio.
In general, the acid test ratio should be at least 1:1 or better. It means that the company has sufficient cash or near cash assets for each unit of its current liabilities. The quick ratio usually reflects a sound, well-managed organisation that is not in danger of imminent collapse, even in the extremely unlikely event that its sales cease immediately. On the other hand, companies with ratios of less than one will not be able to pay their current liabilities and should be looked at with extreme caution.
While a ratio of 1:1 is generally good enough for most creditors, acceptable quick ratios vary by industry as do almost all financial ratios. No ratio is especially meaningful without knowledge of the business from which it originates. For example, a decline in the quick ratio may indicate that a company has built up too much inventory, but it could also suggest that the company has greatly improved its debt collection system. The acid ratio should be seen in the context of the business. Retail stores and jewellery stores carry high volumes or high-value inventory, and this can affect the financial system within the company.
Comparing quick ratios over an extended period can signal developing trends in the company while small declines in the quick ratio do not necessarily spell trouble. Uncovering the reasons for these changes can help explain the bigger picture within the company.
The quick ratio is a snapshot and a company can manipulate its figures to make it look robust at any given point in time.
The acid test ratio is your first look at a company’s financial situation. The next calculation is the current ratio, also known as the working capital ratio, which measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the total current assets including inventories, versus total current liabilities. It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables.
