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

Acid Test Ratio or Quick Ratio.The basis for financial analysis, planning and decision making is financial statements which mainly consist of Balance Sheet and Profit and Loss Account. The profit & loss account shows the operating activities of the concern and the balance sheet depicts the balance value of the acquired assets and of liabilities at a particular point of time.

A ratio is defined as “the indicated quotient of two mathematical expressions and as the relationship between two or more things.” Here ratio means financial ratio or accounting ratio which is a mathematical expression of the relationship between accounting figures.

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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 Quick Ratio is sometimes called the “acid-test” ratio and is one of the best measures of liquidity.

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

Formula to calculate :

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

Quick Ratio or Acid Test Ratio = Quick Assets /Current Liabilities

  • Where, Quick Assets = Current Assets − Inventories − Prepaid expenses
  • Current Liabilities = As mentioned under Current Ratio.

The Quick Ratio is a much more conservative measure of short-term liquidity than the Current Ratio. It helps answer the question: “If all sales revenues should disappear, could my business meet its current obligations with the readily convertible quick funds on hand?”

Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on the belief that these are not ‘near cash assets’ and also because in times of financial difficulty inventory may be saleable only at liquidation value. But in a seller’s market inventories are also near cash assets.

Interpretation An acid-test of 1:1 is considered satisfactory unless the majority of “quick assets” are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying 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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