Acid Test (Quick) Ratio

• Part 10.1 - Common Financial & Accounting Ratios and Formulas
• Part 10.2 - Working Capital & Current Ratio
• Part 10.3 - Acid Test (Quick) Ratio
• Part 10.4 - Accounts Receivable Turnover Ratio

The way current assets are structured is important in determining the company’s short term ability to pay its debts. For instance, cash, cash and equivalents and temporary investments are more liquid than accounts receivable, notes receivable and merchandise inventory. We know that cash and short term investments can be used to pay off debts, pay suppliers, employees’ wages, etc. However, merchandise inventory and accounts receivable must be converted in to cash before they are any good to the company. Thus, an excessive amount of receivables and inventory weakens a company’s ability to pay its current liabilities. One way to test the strength of a company’s current assets is to evaluate the acid-test ratio.

The acid-test ratio is also known as the quick ratio and it conducts a more thorough test of a company’s ability to pay its short term debts by excluding inventory and prepaid expenses from the calculation. Thus, only quick assets are included in the calculation. The quick assets are cash, cash & equivalents, accounts receivable and notes receivable. Thus, the formula for acid-test ratio is:

Notice that the current ratio in 2004 was 3.34 to 1 and it dropped to 1.99 to 1 in the acid-test ratio, a decline of almost 1.34 points which is significant! This is the reason why the acid-test ratio gives us a much more precise outlook of the company’s strength in meeting its short term debt obligations and stay afloat as well as have enough cash on hand to operate effectively. A rule of thumb for evaluating the acid-test ratio is that it must be 1:1 and not less than 1. However, investors prefer this ratio to be as high as possible, even about 1.8 to 1.