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.
Table of Contents
What is the Acid Test Ratio?
The acid test ratio (or 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 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 Acid Test Mean?
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 value.
Notice that the acid test ratio doesn’t include cash flow timing.
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. 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.
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?
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. Current accounts receivable is also called net accounts receivable (reduced by the allowance for doubtful accounts), which estimates collectible accounts receivable.
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.
|Cash and Cash Equivalents||785|
|Accounts Receivable, Net||2,278|
|Total Current Assets||5,495|
|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|
|Accounts Receivable, Net (Current)||2,278|
|Total Current Liabilities as Denominator||3,261|
|Acid Test Ratio||1.076|
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
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 and short-term liabilities on a company’s balance sheet likely convertible to cash within a year.
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. They can turn merchandise inventory into cash through sales instead of writing off inventory balances.
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 translates to a higher acid test ratio and more liquidity.
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.