See how forward-thinking finance teams are future-proofing their organizations through AP automation.
This article defines the acid test ratio and explains why it’s important. We provide a formula for how to calculate acid test ratio. Beyond that, we discuss some levers financial management can use to improve their company’s acid-test ratio results for better financial health.
What is the Acid Test Ratio?
The acid test ratio (quick ratio) is a formula used to determine a company’s ability to pay their bills on time, by comparing their shortest-term assets to their shortest-term liabilities and seeing if they will have enough cash to pay for those immediate liabilities. The acid test ratio doesn’t include current assets that are hard to liquidate, such as inventory, but does include short-term debt.
The acid test ratio is a more stringent financial ratio than the current ratio. Acid test ratio doesn’t include inventory and prepaid assets in the numerator, as does the current ratio.
What Does the Acid-Test Ratio Tell You?
The acid-test ratio is a financial liquidity ratio that tells you whether a company will be able to generate enough cash funds from its most liquid assets in the short term to pay its current liabilities that will be due for payment.
According to the Merriam-Webster Dictionary, the term acid test was coined in 1854 “from the use of nitric acid to determine the gold content of jewelry.” Merriam-Webster defines acid test as a “severe or crucial test.”
When the meaning of acid test is applied, acid test ratio is a crucial test to assess business liquidity.
What is an Acid Test Ratio Interpretation of Results?
With an acid test ratio of at least 1, a company should have adequate liquidity to pay current liabilities when payments are due. But with an acid test ratio of 1, there’s no cushion for error if short-term assets like accounts receivable aren’t converted to cash in time to make payments. The higher the acid test ratio number, the more cash and near-cash liquid assets a company has.
The company’s ability to pay short-term obligations is more assured. But if a high ratio for the acid test is too high, the company may have too much idle cash that could bring higher returns (ROI) if used for strategic growth opportunities. Therefore, a good acid-test ratio is at least 1 but not too high.
If a company’s asset test ratio is too low, lenders may be reluctant to offer financing to the company because insolvency risk is higher. With asset turnover and utilization improvement or turnaround methods, the company’s current assets can be increased, and a low acid-test ratio can be improved.
Companies can benchmark acid test ratios in their industry to the industry average to assess how they’re performing relative to competitors and other industry participants. For example, RMA Statement Studies provides five-year benchmarking data, including financial ratios for small and medium-sized companies. The RMA benchmarking statistics cover almost 600 industries by NAICS code.
How Does the Acid Test Ratio Help in Assessing a Company’s Financial Health?
The acid test ratio helps assess a company’s financial health by quantifying its short-term liquidity and ability to pay supplier invoices, payroll, and other obligations when due from funds that are cash or cash equivalents, short-term investments, and collectible accounts receivable.
The acid test ratio (quick ratio), which is the sum of cash, cash equivalents, marketable securities, and accounts receivable, divided by current liabilities, stringently measures the financial health of a business.
Why is the Acid Test Ratio Important?
The acid test ratio is important because it measures liquidity and a company’s ability to pay its bills and other short-term obligations with short-term assets quickly convertible to cash. Companies without liquidity problems can focus on their competitive strategies for expanding market share without losing corporate control through insolvency or bankruptcy.
How Do You Calculate the Acid Test Ratio Formula?
Calculate the acid test ratio by dividing cash, cash equivalents, marketable securities, and accounts receivable by current liabilities.
The accounting formula for acid test ratio (also known as quick ratio) is:
Cash + Cash Equivalents + Marketable Securities + Current Accounts Receivable
Total Current Liabilities
The acid test ratio equation may also be calculated as:
Total Current Assets – Inventory – Prepaid Assets
Total Current Liabilities
Cash equivalents are certain short-term investments with a maturity term of up to 90 days. Marketable securities, which are classified as a current asset, are unrestricted securities that can be traded on a public exchange to generate cash proceeds from a sale. Current accounts receivable is also called net accounts receivable (reduced by the allowance for doubtful accounts), which estimates collectible accounts receivable.
Current liabilities include accounts payable, accrued expenses (including payroll and employee benefits), and other short-term debt or business obligations payable.
Acid-Test Ratio Example
The following table shows a calculation in Excel using the acid test ratio formula. The numbers are from financial statements. You can find a template or acid ratio test calculator online.
| Current Assets | ($000s) |
| Cash and Cash Equivalents | 785 |
| Marketable Securities | 447 |
| Accounts Receivable, Net | 2,278 |
| Inventory | 1,850 |
| Prepaid Assets | 135 |
| Total Current Assets | 5,495 |
| Current Liabilities | |
| Accounts Payable | 1,114 |
| Accrued Expenses | 424 |
| Other Short-Term Liabilities | 1,015 |
| Current Portion of Operating Lease Liabilities | 164 |
| Current Portion of Long-Term Debt | 544 |
| Total Current Liabilities | 3,261 |
| Acid Test Ratio Calculation: | |
| Cash and Cash Equivalents | 785 |
| Marketable Securities | 447 |
| Accounts Receivable, Net (Current) | 2,278 |
| Total Numerator | 3,510 |
| Total Current Liabilities as Denominator | 3,261 |
| Acid Test Ratio | 1.076 |
How can your business improve its acid test ratio?
Learn how your business can enhance payables for a better acid test ratio through AP automation software. With efficient payables and invoice processing, including global payments in 120 different currencies, set your business for success.
Acid Test Ratio vs Current Ratio
In comparing financial ratios, the acid test ratio vs current ratio, the acid test ratio formula excludes current assets like inventory and prepaid assets. Both the acid test ratio and the current ratio reflect accounts receivable as net of the allowance for doubtful accounts, excluding non-current accounts receivable that aren’t expected to be collected from customers.
The formula for the current ratio is:
Current Ratio = Current Assets
Current Liabilities
Note that the current ratio has the same components as working capital. Current ratio can be considered a working capital ratio. Current assets and current liabilities are short-term assets likely convertible to cash within a year and short-term liabilities on a company’s balance sheet.
The formula for working capital is current assets minus current liabilities:
Working Capital = Current Assets – Current Liabilities
What are Acid Test Ratio Levers to Improve Liquidity?
How to improve the acid test ratio to gain more liquidity requires an understanding of the individual components of the ratio calculation and the entire cash conversion cycle.
The cash conversion cycle is measured in the number of days between using cash to purchase inventory to be sold and collecting accounts receivable as cash when due after the sale.
7 levers to improve the acid test ratio, measuring a company’s liquidity, are:
- Faster inventory turnover
- Speedier and better accounts receivable management
- Sale of idle fixed assets and excess inventory
- Better inventory control
- Better manufacturing quality and process monitoring
- Greater workforce efficiency
- Earning early payment discounts on accounts payable
1 – Faster Inventory Turnover
The Inventory turnover ratio measures the number of times that inventory is sold in a year. The more times the inventory turns, the faster sales are made, and the sooner accounts receivable will be collected as cash. Improving sales team effectiveness and reducing the sales cycle length is beneficial.
2 – Speedier and Better Accounts Receivable Management
Vetting customers for their ability to pay bills when due will lower the risk of uncollectible accounts receivable. If the allowance for doubtful accounts is lower, the acid test ratio is higher. And accounts receivable will be converted to cash more quickly, increasing your company’s liquidity and financial flexibility.
3 – Sale of Idle Fixed Assets and Excess Inventory
If your company has fixed assets like equipment or excess inventory that isn’t being used, the company could receive cash by selling these assets to non-customer buyers. Generating more money increases the acid test ratio.
4 – Better Inventory Control
All businesses with inventory must have adequate internal control over the physical custody and recording of inventory. Retailers have the opportunity to increase the acid test ratio by controlling shoplifting theft. Manufacturing companies need to lock up inventory and record the issuance of inventory to the manufacturing floor for production. They can turn merchandise inventory into cash through sales instead of writing off inventory balances. Companies also need to avoid inventory obsolescence.
5 – Better Manufacturing Quality and Process Monitoring
Manufacturing companies can reduce rework and find potential product defects earlier in the manufacturing process with ERP-integrated smart shop floor software and sensors (IoT) with built-in machine learning alerts. With fewer inventory write-offs requiring cash to replace parts and less rework labor, businesses have more cash and liquidity.
6 – Greater Workforce Efficiency
If employees become more efficient through system automation or other methods, the cash balance is higher if fewer hires are needed. Or, in a turnaround situation, cutting headcount to better align with current requirements reduces the cash drain, increasing liquidity and the acid test ratio.
7 – Earning Early Payment Discounts on Accounts Payable
When your company has better management of accounts payable and payments, it gains the ability to take early payment discounts offered by its vendors. Taking cash discounts reduces the cost of purchases, which means cash balances are higher than they would be if paying the full invoice total. Higher cash and lower accounts payable balances due translate to a higher acid test ratio and more liquidity.
For managing payables, besides considering the acid test ratio, your company can monitor its accounts payable turnover ratio or days payable outstanding (DPO).
FAQ
A frequently asked question (FAQ) and answer about the acid test ratio follow.
Is a 1.5 acid test ratio indicative of a strong financial position?
Yes. A 1.5 acid test ratio is very strong because the business has 33% more in liquid assets than needed to pay its short-term obligations. For every $100 in short-term liabilities, the company has $150 that will be available to pay, giving it a strong financial position.
Takeaways – Acid Test Ratio
- The acid test ratio is a short-term liquidity ratio, also called the quick ratio.
- An acid test ratio of 1 or higher shows the ability of a company to pay short-term financial obligations.
- A low acid-test ratio may prevent a company from getting adequate lender financing.
- A high acid test ratio may signify too much idle cash not effectively used to increase business growth and returns.
- The acid test ratio differs from the current ratio by not including inventory and prepaid assets in the numerator of short-term assets. The acid test ratio numerator only includes quick assets that are liquid current assets readily convertible to cash.
- Companies can apply techniques to increase their acid test ratio and cash balances to improve metrics.
Download “The Holy Grail of Accounts Payable,” to learn about improving your company’s acid test ratio with efficient AP automation.
