What It Measures
How quickly a company’s assets can be turned into cash, which is why assessment of a company’s liquidity is also known as the quick ratio, or simply the acid ratio.
Why It Is Important
Regardless of how this ratio is labeled, it is considered 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 acid-test ratio deducts inventory from current assets before they are compared with current liabilities—which is what distinguishes it from the current ratio.
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. Indeed, the assumption behind the acid-test ratio is that creditors are howling at the door demanding immediate payment, and that an enterprise has no time to sell off its inventory, or any of its stock.
How It Works in Practice
The acid-test ratio’s formula can be expressed in two ways, but both essentially reach the same conclusion. The more common expression is:
Acid-test ratio = (Current assets – Inventory) ÷ Current liabilities
(7,700 – 1,200) ÷ 4,500 = 1.44
A variation of this formula ignores inventory altogether, distinguishes assets as cash, receivables, and short-term investments, and then divides the sum of the three by the total current liabilities:
Acid-test ratio = (Cash + Accounts receivable + Short-term investments) ÷ Current liabilities
If, for example, cash totals $2,000, receivables total $3,000, short-term investments total $1,000, and liabilities total $4,800, then:
(2,000 + 3,000 + 1,000) ÷ 4,800 = 1.25
There are two other ways to appraise liquidity, although neither is as commonly used: the cash ratio is the sum of cash and marketable securities divided by current liabilities; net quick assets is determined by adding cash, accounts receivable, and marketable securities, then subtracting current liabilities from that sum.
Tricks of the Trade
In general, the quick ratio should be 1:1 or better. This means that a company has at least a unit’s worth of easily convertible assets for each unit of its current liabilities. A high quick ratio usually reflects a sound, well-managed organization in no danger of imminent collapse, even in the extreme and unlikely event that its sales ceased immediately. On the other hand, companies with ratios of less than 1 could not pay their current liabilities, and should be looked at with extreme care.
While a ratio of 1:1 is generally acceptable to most creditors, acceptable quick ratios vary by industry, as do almost all financial ratios. No ratio, in fact, is especially meaningful without knowledge of the business from which it originates. For example, a declining quick ratio with a stable current ratio may indicate that a company has built up too much inventory; but it could also suggest that the company has greatly improved its collection system.
Some experts regard the acid-test ratio as an extreme version of the working capital ratio because it uses only cash and equivalents, and excludes inventory. An acid-test ratio that is notably lower than the working capital ratio often means that inventory makes up a large proportion of current assets. An example would be retail stores.
Comparing quick ratios over an extended period of time can be used to signal developing trends in a company. While modest declines in the quick ratio do not automatically spell trouble, uncovering the reasons for changes can help to find ways to nip potential problems in the bud.
Like the current ratio, the quick ratio is a snapshot, and a company can manipulate its figures to make it look robust at a given point in time.
Investors who suddenly become keenly interested in a company’s quick ratio may signal their anticipation of a downturn in the company’s business or in the general economy.