What is Acid Test Ratio?

Acid Test Ratio

Acid Test Ratio/Liquid Ratio/Quick Ratio is a measure of a company’s immediate short-term liquidity. It is calculated by dividing Liquid assets by Current Liabilities. Liquid assets can be termed as those assets which can almost immediately be converted to cash or an equivalent.

Dissimilar to current ratio an acid test ratio doesn’t take into account inventories & prepaid expenses since both of them can’t be seen as liquid assets. Since quick ratio is a better indicator of liquidity or in other words short-term solvency of a business it becomes a crucial ratio to be examined by Banks and NBFCs to check a firm’s short-term debt paying capacity.

 

Formula to Calculate Acid Test Ratio/Quick Ratio/Liquid Ratio

 

Acid Test Ratio

Liquid or Quick Assets = (Total Current Assets – Inventory – Prepaid Expenses)

Acid Test Ratio = (Total Current Assets – Inventory – Prepaid Expenses)/Current Liabilities

 

Example of Acid Test Ratio

Unreal corporation has submitted the below information regarding their current assets and current liabilities, calculate their Acid Test Ratio

 Current Assets  Amt  Current Liabilities  Amt
 Cash & Equivalents  20,000  Outstanding Expenses  15,000
 Marketable Securities   150,000  Provision for Expenses  10,000
 Inventories  40,000  Creditors  20,000
 Debtors  20,000  Bills Payable  15,000
 Prepaid Expenses  10,000    
       
 Total  2,40,000  Total  60,000

 

Calculation:

(Liquid Assets or Quick Assets)/Current Liabilities

(Total Current Assets – Inventory – Prepaid Expenses)/Current Liabilities

(2,40,000 – 40,000 – 10,000)/60,000

1,90,000/60,000

3.16

In the above example the business has 3.16 Units of liquid assets for every 1 Unit of their short-term liabilities. Looking from the perspective of short-term solvency the company in this case is in a favorable condition.

Usually 1:1 is an acceptable number for acid test ratio since it shows that the business has 1 unit of quick asset for every 1 unit of short-term obligation. A lower ratio than 1:1 indicates financial difficulty for the business.