Acid Test Ratio or Quick Ratio – Formula to calculate, importance

Acid Test Ratio or Quick Ratio. Find Full details for Quick Ratio. Here we are providing complete details for Acid Test Ratio like Definition of Acid test Ratio, Formula of Acid Test Ratio, Use of Acid test ratio. Recently we also provide Balance of payments (BOP) & Its components. Now you can scroll down below and check more details regarding.

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1. Acid Test Ratio :

The acid test ratio is a measure of how well a company can meet its short-term financial liabilities.
In simple terms it is a good indicator that determines whether an entity has enough short-term assets to cover its immediate liabilities without selling inventory.

The acid-test ratio is far better indicator than the working capital ratio, primarily because the working capital ratio allows for the inclusion of inventory assets as well which may not be readily realized into liquidity.

Must Read – Profit Centre – Meaning, Definition, Importance & Example

Formula to calculate :

Acid-Test Ratio = (Cash Marketable Securities Accounts Receivable) /Current liabilities

Use of this ratio :

For example if the Acid-test ratio of xyz ltd is greater than 1 it’s a very healthy condition of company’s capability to release their short term obligations.

If the Acid-test ratio of xyz ltd is less than 1 it means the company can not pay their current liabilities and should be looked at with extreme caution. Further if the acid-test ratio is much lower than the working capital ratio, it means current assets are highly dependent on inventory which is not rapidly convertible to cash.

importance :

Obviously, it is essential that a company have enough cash and cash equivalents to meet accounts payable, interest expenses, and other bills when they become due. The higher the ratio, the more financially secure a company is in the short term. As explained above there is a common rule is that companies with a Acid-Test or quick ratio of greater than 1 are sufficiently able to meet their short-term liabilities.

Limitations :

The acid test ratio assumes that accounts receivable can be readily convertible into liquid cash, which may not be the possible scenario for many companies. Finally, the formula assumes that a company would liquidate its current assets to pay current liabilities, which is not always realistic, considering some level of working capitalis needed to maintain operations.

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