Lynne has taught accounting and financial statement analysis courses for more than 20 years.
When you hear words like 'acid test' and 'liquidity', do your thoughts jump immediately to a high school chemistry class? You might be surprised to learn that these terms are actually used in the financial industry as well.
Liquidity refers to the ability of a company to come up with the cash it needs as it needs it, an important aspect of the financial health of a business. One measure of liquidity is the acid test ratio. The acid test ratio is also referred to as the quick ratio.
The numbers used in the calculation of the acid test ratio are taken from the most recent balance sheet of the business. The concept behind this ratio is to measure how well the company's cash or 'near cash' assets could cover the liabilities it owes in the coming twelve months. This is calculated using the following formula:
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While other liquidity measures take into account additional assets a business has, such as inventory that could be sold to generate cash, the acid test ratio is more conservative. The only assets that are included as available to pay debts are cash accounts, marketable securities (investments that could be quickly sold) and accounts receivable. Accounts receivable are amounts due to the company from its customers for service or merchandise that has already been provided. These receivables are typically collected in 30-60 days and are therefore considered to be liquid.
The result of the calculation is expressed as a multiple, with the number followed by an 'x', such as 2.5x. When said aloud, the result is read as '2.5 times', meaning that the numerator is 2.5 times as large as the denominator.
The acid test ratio is an example of a coverage ratio. You are measuring how well the assets in the numerator would cover the liabilities. An acid test ratio of 1.0x indicates that the assets available today would exactly cover the liabilities due in the coming year.
A higher ratio means that those assets would be enough to cover the liabilities with money left over. For example, an acid test ratio of 2.0x means that the business could cover by two times. Obviously the liabilities would not have to be paid more than once -- the fact that the business could potentially come up with twice as much cash as it needs provides a cushion, or a margin for error. Higher acid test ratios indicate stronger, or more favorable, liquidity.
Acid test ratio results can also be less than 1.0x, when the business has more short-term liabilities than liquid assets. For example, an acid test ratio of .72x indicates that the liquid assets the business has on hand now would cover 72% of the liabilities coming due in the next year. Of course as long as the company is an ongoing business that continues to make sales, it will continue to generate additional cash and receivables to help cover those needs as well.
Consider a business that shows the following information on its most recent partial balance sheet:
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The acid test ratio in this example would be 1.75x, which is calculated as follows: $50 cash + $100 marketable securities + $200 accounts receivable / $200 short-term liabilities. The result shows strong liquidity, with liquid assets on hand that are sufficient to cover the liabilities coming due in the next twelve months by almost two times.
The acid test ratio is a useful measure of the liquidity of a business. It is calculated by adding cash, marketable securities and accounts receivable and dividing that sum by short-term liabilities. An acid test ratio provides insight as to how easily the company can come up with cash to cover its upcoming obligations, a critical financial success factor. Along with other financial statement ratios, the acid test ratio can help you determine the overall financial health of a company.
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