Acid-Test Ratio Definition, Meaning Formula and Examples

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acid-test ratio

Definition of Acid-Test Ratio

Definition of Acid-Test Ratio – A measure of a company’s ability to meet its short-term obligations also called quick ratio or liquid ratio.

Acid-Test Ratio Meaning –  Acid Test ratio is a tool to measure the organization’s financial liquidity in order to meet its current liabilities. It is basically the ratio of quick assets to current liabilities. This ratio is considered more appropriate in measuring firm’s liquidity as compared to Current Ratio.

Acid-Test Ratio Formula = Quick Assets / Current Liabilities

Quick Assets = Marketable securities + Cash /Cash equivalents + Accounts Receivable + Short term                                      Investment

Note : Quick assets does not include inventory

Current Liabilities = Bills Payable + Accounts Payable + Outstanding amounts + others

Quick assets refers to assets that are easily convertible into cash within the 1 year period.  Quick assets do not involve inventory. As one cannot say about their conversion time into cash. However, accounts receivable adds to quick assets. Though they are inventory but are easily convertible into cash

Current Liabilities are the liabilities of the firm that they require to pay within the period of 1 year. In simple words these are short terms loans whose maturity period is restricted to the duration of 1 year.

Acid-Test Ratio Example

Here is the real life example of Acid test ratio or quick ratio.

  Cash       2000
 Marketable Securities       5000
 Account Receivables       1000
Inventory 3000
 Cash Equivalents 10000
 Total Current Assets  21000
 Bills Payable  5000
Outstanding Rent3000
Accounts Payable3000
 Total Current Liabilities11000

Quick/ Acid test Ratio = (2000 +5000 + 1000 + 10000) / 11000

=  18000/11000

= 1.6

Related Financial Terms of Acid-Test Ratio

Interpretation of Acid-Test Ratio – Why Acid Test Ratio is Used?

The ideal Acid Test ratio is 2:1. It is always good for organization to have liquid assets twice their current liabilities. If the ratio is 1:1, it means that the current liabilities are equal to the liquid assets that company has. However, this is quite stressful condition for the firm. As after meeting out liabilities, firm will have to face cash shortage.

If the ratio is less that 1, that means firm do not have sufficient liquidity with itself. This signifies that company is struggling for increasing their sales. It also indicates that firm is paying their Accounts payable quickly but receiving accounts receivables slowly.

Higher quick ratio means , organization is on the verge of growth. In addition to this, quickly turning their accounts receivables into cash. At the same time, too much higher liquidity ratio is also not good. This means that the cash is kept idle and is not invested anywhere. This is also not a good sign for the company. However, for every industry, the acid – test ratio may differ but mostly take 2:1 as the idle ratio or ratio more than 1.

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