What is Acid-Test Ratio?
An acid-test ratio, also known as a quick ratio, is a financial measure of a company’s ability to pay off its current liabilities – that is, any debt that will need to be repaid within a year, such as credit card charges and accounts payable. The acid-test indicates whether a business can pay off such debt immediately using cash or current assets. It’s one measure of a company’s short-term financial health.
To calculate a company’s acid-test ratio, use this formula:
Acid-test ratio = (cash + accounts receivables + short-term investments)/current liabilities
Essentially, you add all the available liquid assets – money that the company could tap into in a pinch – and divide it by the amount of short-term debt the company has.
What Does it Mean?
Acid-test ratios less than 1 may mean the company does not currently have sufficient current assets to cover its current liabilities. But not always.
Retail businesses typically have very low acid-test ratios because they are heavily invested in inventory. That inventory dependence drives up their current liabilities but does not necessarily mean that they are financially troubled. Some of the largest big box retailers in the country typically have acid-test ratios below .50 and are quite profitable.
Such an acid-test ratio might look something like this:
$500,000/$1,000,000, which = .50.
That means that even after liquidating all of the company’s current assets, it still doesn’t have enough available to pay off its short-term debt, if it had to. And that’s the key issue. Very rarely will an established company have to pay 100% of its current liabilities all at once, and it’s possible that a large influx of orders could provide enough additional cash next month to radically change that ratio.
On the other hand, a solid acid-test ratio might look something like this: $500,000/$100,000, which = 5. The company can easily cover its current liabilities.
An acid-test ratio is one measure of a company’s financial health at one moment in time.