The acid-test ratio, also known as the quick ratio, uses a company’s balance sheet data to assess its capacity to cover short-term liabilities. A ratio of 1.0 or more indicates that the company can meet its short-term obligations, while a ratio of less than 1.0 suggests potential liquidity issues.
Key Takeaways
- The acid-test or quick ratio compares a company’s liquid assets to its short-term liabilities to evaluate whether it can cover immediate financial obligations.
- It excludes current assets that are challenging to liquidate swiftly, such as inventory.
- The acid-test ratio may not accurately reflect a company’s financial health if accounts receivable take longer to collect or if some liabilities are due imminently without immediate payment requirements.
Understanding the Acid-Test Ratio
In certain scenarios, analysts prefer the acid-test ratio over the current ratio because the former excludes assets like inventory that are not easily liquidated. This makes the acid-test ratio a more conservative measure.
Companies with an acid-test ratio of less than 1.0 lack sufficient liquid assets to cover current liabilities and should be approached cautiously. However, this can vary with the nature of the business. Retailers, for instance, might inherently have low acid-test ratios without being in financial danger.
For most industries, an acid-test ratio above 1.0 is considered healthy. However, a very high ratio could indicate that cash is being underutilized, rather than reinvested, distributed to shareholders, or employed for productive use. Higher ratios are often noted in cash-rich industries, notably tech.
Calculating the Acid-Test Ratio
To calculate the acid-test ratio, consider liquid assets such as cash and cash equivalents, short-term marketable securities, and accounts receivable. Avoid including less liquid current assets like inventory.
Formula:
Acid Test = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
Items like advances to suppliers, prepayments, and deferred tax assets should be excluded from the numerator. The denominator should encompass all current liabilities, including debts due within a year.
The time factor isn’t represented in the acid-test ratio. A company with significant upcoming payables versus receivables due much later may appear secure based on this ratio but might actually be at risk, and vice versa.
Acid-Test Ratio Example
Here’s an example using Apple’s balance sheet (figures in millions):
| Item | Amount |
|---|---|
| Cash and cash equivalents | 37,119 |
| Short-term marketable securities | 26,795 |
| Accounts receivable | 30,213 |
| Inventories | 5,876 |
| Vendor non-trade receivables | 35,040 |
| Other current assets | 18,112 |
Total current assets: 153,154
| Item | Amount |
|---|---|
| Accounts payable | 74,362 |
| Other current liabilities | 49,167 |
| Deferred revenue | 7,876 |
| Commercial paper | 5,000 |
| Term debt | 11,169 |
Total current liabilities: 147,574
Calculation:
Apple's ATR = (37,119 + 26,795 + 30,213 + 35,040) ÷ (74,632 + 49,167) = 1.05
Keep in mind, calculation methods can differ among analysts, indicating the importance of understanding how conclusions are derived.
Current vs. Acid-Test Ratios
Both ratios assess a company’s ability to pay short-term debts but do so differently:
- Current Ratio: Includes all current assets, more lenient.
- Acid-Test Ratio: More conservative, includes only highly liquid assets.
What Does the Acid-Test Ratio Tell You?
The acid-test ratio reveals a company’s immediate liquidity. An acceptable ratio is typically over 1.0, indicating adequate liquidity. A lower ratio or over-reliance on inventory for current assets could signal liquidity risk. Conversely, a very high ratio may indicate inefficient cash utilization.
How Do You Calculate the Acid-Test Ratio?
Calculate it by dividing the sum of current cash, marketable securities, and accounts receivable by current liabilities, using balance sheet data.
The Bottom Line
The acid-test or quick ratio is crucial for measuring a company’s short-term liquidity. Generally, a ratio above 1.0 signifies the ability to meet short-term obligations. However, industry norms should guide its application for accurate assessment.
Related Terms: current ratio, liquidity ratios, balance sheet, financial statements, accounts receivable
References
- Apple. “1/27/22 Apple Reports First Quarter Results”, Page 2.
