The acid test ratio, also known as quick ratio, refers to the group of liquidity ratios. It measures the ability of a company to immediately cover its current liabilities using only quick assets. Please note that quick assets are current assets that can be converted into cash in less than 90 days.
The quick ratio can be calculated using the following formula:
Cash includes all money in domestic and foreign currency that a company has in bank accounts, cash registers, and any other depository.
Cash equivalents represent short-term investments that can be quickly transformed into cash. These are usually money market securities, such as U.S. Treasury bills.
Investments represent short-term investments expected to be sold in the current period or mature in less than 90 days. They are usually marketable securities, such as money market instruments, highly liquid stocks expected to be sold in the current period, and short-term bonds.
Receivables are usually accounts receivable due within 30 to 90 days. The total of accounts receivable due later than 90 days should be excluded when calculating quick ratio.
Prepaid expenses are paid before they will be fully consumed in the current period. For example, a one-year insurance policy is usually paid up front and consumed within the next 12 months. Please note that they can’t be converted into cash; thus, they don’t refer to quick assets.
Inventory consists of merchandise, raw materials, work in progress, and finished goods. It usually takes more than 90 days to convert inventories into cash, so they can’t be classified as quick assets.
The balance sheet of XYZ company is as follows:
US$ in thousands
In the notes to financial statements, it was stated that in the current year a portion of the accounts receivable amounted to $680,000 due later than 90 days.
Using the formula above and information available, the quick ratio of XYZ company in the prior year was 1.303 and 1.053 in the current year.
We note that a portion of accounts receivable in the current year is due later than 90 days, so the adjusted quick ratio in the current year is 0.944. This value more correctly describes the ability of the company to immediately meet its current liabilities.
The quick ratio for XYZ company in the current year is 1.053, which compared with the baseline of 1.303 indicates reducing its ability to service short-term obligations.
Quick ratio analysis
Generally, the acid test ratio should be high because it indicates that a business has a strong ability to meet its current liabilities. Some academic studies suggest using 1 as a threshold value because it indicates an ability of a business to immediately cover its short-term obligations using only quick assets.
When a quick ratio analysis is performed, the industry average comparison is important. It helps to determine whether or not a business’s liquidity is better than average in its particular industry. Let’s consider the example above and assume the industry average in the current year is 0.873.
Although the value of the ratio decreased in the current year, it remains above the industry average, which indicates a favorable ability to service short-term obligations.
You can also calculate the quick ratio using our online calculator.