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Acid-Test Ratio – Definition

Acid Test Ratio Definition

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.

A Little More on What is the Acid Test Ratio

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.

References for Acid Test

Academic Research on Acid Test

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