A liquidity ratio that focuses on a company’s highly liquid assets as it disregards all but the most liquid of current assets. It is a more conservative version of the current ratio, since it excludes inventory which is by nature an asset that cannot rapidly be converted to cash. In severe circumstances, inventory items would be liquidated at unfavorable terms, i.e., selling at substantially below-market prices. In many cases, prepaid expenses should also be excluded as they either cannot be converted to cash or are for expenses incurred that are being amortized over an estimated life.
The acid test ratio can be calculated by adding up cash, marketable securities and accounts receivable and dividing the sum by current liabilities. Alternatively, calculation can be done as in the following formula:
(Current assets- inventories- accruals- prepaid items)/ (current liabilities)
This ratio helps measure the efficiency of a company’s liquidity position and determines how fast it can convert its accounts receivable into cash. Companies that cannot easily convert accounts receivables to cash can run into liquidity problems.
Because business operations vary across industries, and even within the same industry, it is more fitting to compare companies within the same industry or a subsector in an industry. Many lending institutions and financing facilities prefer to use the acid test ratio as one of the measures of a company’s management effectiveness. Assuming a company is able to smoothly collect its receivables, an acid test ratio of 1 to 1 or better is typically satisfactory.
The acid test ratio is also known as the quick ratio.
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