How do you calculate the acid test ratio
The acid test ratio measures how easily a company can pay debts using its most liquid assets, especially short-term assets. The formula for calculating the ACID Test Ratio is:
(Cash + Marketable Securities + Accounts Receivable) divided by total current liabilities.
The acid test ratio is a stricter measure of solvency than the current ratio. It only considers highly liquid assets in the numerator. The blog will show the formula and how to calculate it.
What is the formula for the acid test ratio?
The acid test ratio formula is: Acid test ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities. Cash includes cash on hand and easily convertible short-term investments. Investors can easily sell marketable securities such as stocks, bonds, and mutual funds.
Accounts receivable are the amounts owed by customers for goods or services delivered on credit. Current liabilities are debts that must be paid within a year, like bills, loans, expenses, and taxes.
How to calculate the acid test ratio with an example?
To calculate the acid test ratio, you need to obtain the relevant data from the company's balance sheet. For example, suppose that a company has the following balances as of February 28, 2023:
Cash and cash equivalents: R50,000
Marketable securities: R100,000
Accounts receivable: R150,000
Inventory: R200,000
Prepaid expenses: R25,000
Total current assets: R525,000
Accounts payable: R75,000
Short-term debt: R100,000
Accrued expenses: R50,000
Taxes payable: R25,000
Total current liabilities: R250,000
To find the acid test ratio, add cash, marketable securities, and accounts receivable, then divide by total current liabilities. In this case, the acid test ratio is: Acid test ratio = (R50,000 + R100,000 + R150,000) / R250,000 Acid test ratio = 1.2 This means that the company has R1.2 of quick assets for every R1 of current liabilities.
Why is the acid test ratio important?
The acid test ratio is important. It shows how well a company can pay its short-term debts. It does this without selling inventory or less liquid assets. A high acid test ratio means the company has enough money to pay bills and handle unexpected expenses or opportunities.
A low acid test ratio suggests that the company may face cash flow problems or have difficulty accessing credit in the market. A ratio of 1 or more is usually okay, but it can change depending on the industry and type of business.
What are the limitations of the acid test ratio?
When interpreting the results, one should consider the limitations of the acid test ratio, just like any other financial ratio. It doesn't show how good or valuable the money owed is, which can be affected by unpaid debts, discounts, or deductions.
Furthermore, it does not account for the timing or seasonality of the cash inflows and outflows, which may differ from the balance sheet date. Additionally, it does not consider the profitability or growth potential of the company, which may influence its ability to generate cash from its operations or investments. Ultimately, the acid test ratio is not comprehensive enough to provide a full picture of the company's financial performance or position and should be used in combination with other ratios and indicators.
What are some variations of the acid test ratio?
You can adjust the acid test ratio for different factors or preferences, such as the cash ratio. This variation only looks at cash and marketable securities, not accounts receivable, making it a more cautious measure of liquidity.
The super quick ratio is very strict. It only looks at cash and cash equivalents, not accounts receivable or marketable securities. The modified quick ratio is a better measure of liquidity. It includes inventory in the numerator. However, it deducts a certain percentage to account for potential obsolescence or markdown.
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