What is the Acid Test?

The Acid Test Ratio, also known as the Quick Ratio, is a liquidity ratio that measures whether a firm possesses enough short term assets to cover its current liabilities. It estimates how a firm can efficiently settle its short-term financial obligations should the need arise.

Quick ratio = Quick Assets  / Net Current liabilities

Note: Quick assets are generally (Cash + Marketable securities + Short-term receivables)

How is the Quick 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.

Related Topics

• Trend Analysis of Financial Statements
• Common-Size Analysis (Vertical Analysis) of Financial Statements
• Common-Size Financial Statement
• Net Dollar Retention
• Horizontal Analysis
• Per Share Basis
• Profitability Ratios
• Gross Margin Ratio
• Profit Margin
• After Tax Profit Margin
• Return on Assets
• Total Shareholder Return
• Cash on Cash Return
• Earnings Per Share
• Diluted Earnings Per Share
• Asset Turnover Ratio
• Berry Ratio
• Break-Even Analysis
• Liquidity Ratio
• Current ratio  (Working Capital Ratio)
• Working Ratio
• Quick Ratio
• Quick Assets
• Days Sales Outstanding
• Cash Ratio (Operating Cash Flow Ratio)
• Receivables turnover ratio (often converted to average collection period)
• Accounts Payable Turnover Ratio
• Inventory turnover ratio (often converted to average sale period)
• Solvency (Coverage Ratios)
• Leverage Ratio (Debt Ratio)
• Asset Coverage Ratio
• Debt to Equity
• Debt to Income Ratio
• Debt Coverage Ratio
• Times Interest Earned
• Market Capitalization
• Price to Equity Ratio
• Book-To-Market Ratio
• Price to Earnings Ratio
• Price to Earnings Growth (PEG) Ratio
• Price to Earnings Growth Payback Ratio
• CAPE Ratio
• Price to Cash Flow Ratio
• Capital Maintenance
• Book to Bill Ratio
• Asset Turnover Ratio
• Plowback Ratio 
• Days Inventory Outstanding
• Days Payable Outstanding
• Days Sales Outstanding
• Non-financial Performance Measures: The Balance Scorecard