Acid-Test Ratio - Explained
What is the Acid-Test Ratio?
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Table of ContentsWhat is the Acid Test?How is the Acid Test Ratio Used?Acid Test CalculationInterpretation of Acid Test ResultsAcademic Research on Acid Test
What is the Acid Test?
The Acid Test is a liquidity ratio that measures whether a firm possesses enough short term assets to cover its current liabilities. It is also known as the quick ratio. It estimates how a firm can efficiently settle its short-term financial obligations should the need arise.
Back to: ACCOUNTING, TAX, & REPORTING
How is the Acid Test Ratio Used?
The acid test ratio determines whether a company is a solvent in the short term and how the assets available to the company are detailed financially. It establishes a comparison of what a company has in the short term and what it should have, and this helps in identifying whether there is a problematic lag. The ratio is quick and easy to calculate. It shows how the resources of a company are managed and if there is a weakness that the market might penalize. This ratio involves dividing the current assets (minus inventories) due to their high liquidity (can be easily converted into cash) by the current liabilities One of the uncertainties that investors face while investing in a company is that the company might encounter economic difficulties and end up breaking. If this happens, the investors might lose all their money. Since the future of their investment depends on the future of the company, investors like to know if a company is likely to get into difficulties and they use the quick ratio to find out.
Acid Test Calculation
Acid test = (Current assets Inventories) / Current Liabilities Current assets consist of items which can be easily converted into cash within a maximum period of one year as is the case of;
- Clients and debtors who can be charged after a few weeks or months
- The stock which is sold in exchange for liquid cash.
- Cash and this is always present in a company.
Interpretation of Acid Test Results
When the result of the acid test is less than one, it means that the company's current liabilities exceed its current assets and the company should soon sell part of its stock to meet its short term obligations. This indicates that measures should be taken to make sure that the company is not in danger of insolvency. The acid test is, therefore, an essential tool that helps investors to avoid taking unnecessary risks.
Academic Research on Acid Test
- Impacts of liquidity ratios on profitability, Saleem, Q., & Rehman, R. U. (2011). Interdisciplinary Journal of Research in Business, 1(7). This research paper explains how liquidity ratios can affect the profitability of a company either negatively or positively.
- Liquidityprofitability tradeoff: An empirical investigation in an emerging market,, Eljelly, A. M. (2004). International journal of commerce and management, 14(2), 48-61. This study uses a sample of joint stock companies in Saudi Arabia to examine the relation existing between profitability and liquidity by using cash ratio and cash gap.
- Liquidity analysis using cash flow ratios and traditional ratios: The telecommunications sector in Australia, Kirkham, R. (2012). Journal of New Business Ideas & Trends, 10(1), 1-13. This study's primary objective is to reveal the differences existing between the traditional liquidity ratios and the cash flow ratios.
- Trade-off between liquidity & profitability: A study of selected manufacturing firms in Sri Lanka, Niresh, J. A. (2012). Researchers World, 3(4), 34. This study examines the cause and effects of relationships existing between profitability and liquidity. It attempts to find out whether too much attention on profitability can dilute the liquidity position of a company thereby leading it into a pitfall.
- An empirical test of financial ratio analysis for small business failure prediction, Edmister, R. O. (1972). Journal of Financial and Quantitative analysis, 7(2), 1477-1493. This paper attempts to develop and test various methods that can be used to analyze financial ratios and predict the failure of small businesses. It further explains that even though all the ratios do not anticipate failure, most of the ratio variables are found to predict the failure of Business Administration borrowers and the guarantee recipients.
- Financial ratios as a means of forecasting bankruptcy, Tamari, M. (1966). Management International Review, 15-21. This paper uses financial ratios to try and forecast bankruptcy in an organization for managers to develop measures and avoid it.
- Changes in working capital of small firms in relation to changes in economic activity, Lamberson, M. (1995). American Journal of Business, 10(2), 45-50. This study was carried out on forty firms from 1980-1991 to examine how small firms responded to the changes in economic activity level.
- Corporate liquidity and the significance of earnings versus cash flow, Lancaster, C., Stevens, J. L., & Jennings, J. A. (1998). Journal of Applied Business Research, 14, 27-38. This study extends the work on the existence of the relationship between liquidity and accrual income versus cash flow that appeared in this journal. However, it expands the measure of corporate liquidity to support the inclusion of static liquidity and dynamic liquidity.
- The relationship of cash conversion cycle with firm size and profitability: an empirical investigation in Turkey, Uyar, A. (2009). International Research Journal of Finance and Economics, 24(2), 186-193. This article has several objectives which include examining and developing industry benchmarks for cash conversion cycle of manufacturing and merchandising companies, the size of the firms together with the length of the cash conversion cycle and the length of the cash conversion cycle and profitability.
- Impact of liquidity and solvency on profitability chemical sector of Pakistan, Khidmat, W., & Rehman, M. (2014). Economics management innovation, 6(3), 34-67. This paper researches data collected from ten listed companies sampled from the chemical sector of Pakistan over nine years from 2001 -2009. It then develops a model to be used to increase the liquidity and profitability of a company effectively.
- The impact of liquidity on the capital structure: a case study of Croatian firms, arlija, N., & Harc, M. (2012). This study finds out that firms that have more liquid assets are less leveraged while firms that which enjoy long term leverage also have more liquidity.
- Financial ratio analysis comes to nonprofits, Chabotar, K. J. (1989).The Journal of Higher Education, 60(2), 188-208. This article investigates the strengths and weaknesses present in ratio analysis to provide a detailed suggestion on how nonprofit organizations can use it effectively.