Definition of 'Acid Test'
Otherwise known as the quick ratio, the acid test ratio helps businesses determine if they have enough short term assets to meet current liabilities. The acid test is preferable over the current ratio because it doesn’t take illiquid assets into consideration, which could blur the true measure of the ability to pay.
TheStreet Explains ‘Acid Test’
The acid test ratio is an important measure because it provides insight into whether a company can cover its accounts payable, interest on loans, and bills with the cash the company has on hand. The higher the ratio, the better the position the company is in terms of financial security.
To calculate the acid test ratio, divide the cash + accounts receivable + short term investments by current liabilities.
In general terms, companies with an acid test ratio of 1 or above are considered to be less risk than those holding a ratio of less than 1. A company with an acid test ratio less than 1 means the business cannot cover its immediate liabilities with cash on hand. Although a negative acid test ratio indicates trouble, the company’s industry should be considered. For instance, retail companies historically have a lower asset test ratio because inventories are not considered with this ratio. Even though a particular retailer could be successful, the company’s acid test ratio could indicate otherwise.
Although an acid test ratio over 1 is good, an extremely high ratio means the company may be sitting on a pile of cash and not using it efficiently by reinvesting it. Again, some industries may carry a higher than average acid test ratio, such as tech companies, because goods may be based more on services and intelligence/staffing rather than material objects or items.
The acid test ratio is an important metric, but not without its drawbacks. One limitation is the ratio used on its own may not provide enough information to sufficiently analyze the company’s entire picture of liquidity. Also, not taking inventory into consideration for some types of industries may be inappropriate if the business is inventory-heavy. Additionally, cash flow timing is vital for some businesses, especially those who rely upon activity on a seasonal or quarterly basis, so the acid test ratio may appear differently depending upon the time of year.
Terms Related to 'Acid Test':
The current ratio, calculated as current assets divided by curre...
Quick ratio is the result signifying a company’s short-term liquidi...
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