Acid-test ratio: What is it?

Definition

The acid-test ratio, also known as the quick ratio, is a financial metric used to evaluate a company’s ability to cover immediate financial obligations without relying on the sale of inventory.

What is an acid-test ratio?

The acid-test ratio is calculated using the following formula:

Acid-test ratio = current asset – inventory / current liabilities

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Key points about the acid-test ratio:

Focus on short-term liquidity: It specifically looks at a company’s ability to meet its short-term obligations without relying on the sale of inventory.
Stringent measure: By excluding inventory, the acid-test ratio provides a more conservative measure of a company’s ability to cover its current liabilities.
Ideal ratio: A ratio of 1 or higher is generally considered satisfactory. This means that the company has enough liquid assets to cover its current liabilities.
Comparison and analysis: It’s important to compare the acid-test ratio with industry benchmarks and the company’s historical performance to get a sense of its financial health.
Limitations: While the acid-test ratio provides valuable insights into short-term liquidity, it doesn’t provide a complete picture of a company’s overall financial health.

Overall, the acid-test ratio is a valuable tool for assessing a company’s ability to meet its short-term financial obligations, providing insights into its liquidity position and financial risk.

Example of acid-test ratio

Balance sheet information:

- ABC Retail’s balance sheet, as of a specific date, shows the following relevant figures:
  - Current assets: R100,000
  - Inventories: R20,000
  - Current liabilities: R40,000
Calculation of acid-test ratio:
- Using the formula, you can calculate the acid-test ratio:
  $Acid-test ratio = (R 100 , 000 - R 20 , 000) / R40,000 = 2$
The acid-test ratio for ABC Retail is 2, meaning the company has R2 in quick assets available to cover each R1 of current liabilities.