Definition
The acid-test ratio, also called the quick ratio, is a financial metric that measures a company’s ability to pay off its current liabilities using its most liquid assets. The formula to calculate the acid-test ratio is:
\[ \text{Acid-Test Ratio} = \frac{\text{Cash + Marketable Securities + Accounts Receivable}}{\text{Current Liabilities}} \]
This ratio excludes inventory from current assets, as inventory is not as rapidly convertible into cash as other liquid assets.
Examples
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Example 1: A Retail Company
- Cash: $20,000
- Marketable Securities: $10,000
- Accounts Receivable: $15,000
- Current Liabilities: $30,000
The acid-test ratio would be:
\[ \text{Acid-Test Ratio} = \frac{20,000 + 10,000 + 15,000}{30,000} = \frac{45,000}{30,000} = 1.5 \]
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Example 2: A Manufacturing Firm
- Cash: $5,000
- Marketable Securities: $3,000
- Accounts Receivable: $12,000
- Current Liabilities: $18,000
The acid-test ratio would be:
\[ \text{Acid-Test Ratio} = \frac{5,000 + 3,000 + 12,000}{18,000} = \frac{20,000}{18,000} \approx 1.11 \]
Frequently Asked Questions (FAQs)
What does a high acid-test ratio indicate?
A high acid-test ratio indicates that a company has a strong ability to meet its short-term liabilities without relying on the sale of inventory. Typically, a ratio greater than 1 is desirable.
What is the difference between the current ratio and the acid-test ratio?
The current ratio includes all current assets, such as inventory, in its calculation, whereas the acid-test ratio excludes inventory for a more stringent test of liquidity.
Can the acid-test ratio be too high?
Yes, an excessively high acid-test ratio may indicate that a company is not efficiently utilizing its assets or is holding too much cash.
What are liquid assets in the context of the acid-test ratio?
Liquid assets include cash, marketable securities, and accounts receivable—assets that can be quickly converted into cash with minimal impact on their value.
Why does the acid-test ratio exclude inventory?
Inventory is excluded because it is not as easily and quickly converted into cash as other current assets.
- Current Ratio: A liquidity ratio that measures a company’s ability to cover its short-term obligations with its current assets.
- Liquidity: The ability of an asset to be quickly converted into cash.
- Working Capital: The difference between a company’s current assets and current liabilities.
- Cash Ratio: A strict liquidity ratio measuring the ability to cover short-term obligations with only cash and cash equivalents.
- Operational Efficiency: A measure of how well a company uses its assets to generate income.
Online References
Suggested Books for Further Studies
- “Financial Statement Analysis and Security Valuation” by Stephen H. Penman
- “Principles of Corporate Finance” by Richard A. Brealey and Stewart C. Myers
- “Financial Accounting: An Introduction to Concepts, Methods and Uses” by Roman L. Weil
Accounting Basics: “Acid-Test Ratio” Fundamentals Quiz
### What is another term for the acid-test ratio?
- [ ] Debt-to-Equity Ratio
- [ ] Gross Margin Ratio
- [x] Quick Ratio
- [ ] Return on Assets
> **Explanation:** The acid-test ratio is also known as the quick ratio. It measures a company's liquidity by considering only the most liquid assets.
### What assets are included in the calculation of the acid-test ratio?
- [x] Cash, Marketable Securities, and Accounts Receivable
- [ ] Cash, Inventory, and Prepaid Expenses
- [ ] Inventory, Accounts Receivable, and Fixed Assets
- [ ] Cash, Property, and Equipment
> **Explanation:** The acid-test ratio includes cash, marketable securities, and accounts receivable in its calculation. It excludes inventory as it is not as liquid.
### What does an acid-test ratio greater than 1 signify?
- [ ] The company has more liabilities than assets.
- [x] The company can cover its short-term liabilities with its liquid assets.
- [ ] The company is profitable.
- [ ] The company has high fixed costs.
> **Explanation:** An acid-test ratio greater than 1 signifies that the company has enough liquid assets to cover its short-term liabilities.
### Why is inventory excluded from the acid-test ratio?
- [ ] It is a long-term asset.
- [x] It is not as quickly convertible into cash.
- [ ] It is an irrelevant asset.
- [ ] It depreciates over time.
> **Explanation:** Inventory is excluded because it is not as quickly convertible into cash as other liquid assets like cash or accounts receivable.
### Which of the following scenarios would be concerning for investors?
- [ ] An acid-test ratio of 2
- [x] An acid-test ratio of 0.5
- [ ] An acid-test ratio of 1.5
- [ ] An acid-test ratio of 1
> **Explanation:** An acid-test ratio of 0.5 indicates the company may not be able to cover its short-term liabilities with its liquid assets, which is concerning for investors.
### How is the acid-test ratio different from the current ratio?
- [ ] There is no difference.
- [ ] The acid-test ratio includes inventory.
- [ ] The acid-test ratio includes long-term liabilities.
- [x] The acid-test ratio excludes inventory.
> **Explanation:** The primary difference is that the acid-test ratio excludes inventory, providing a more stringent measure of a company's liquidity.
### Which term best describes the acid-test ratio?
- [ ] Leverage Ratio
- [x] Liquidity Ratio
- [ ] Profitability Ratio
- [ ] Efficiency Ratio
> **Explanation:** The acid-test ratio is a type of liquidity ratio, which measures a company's ability to meet its short-term obligations.
### If a company's marketable securities increase, what is the likely impact on the acid-test ratio?
- [ ] It will decrease.
- [ ] It will remain the same.
- [x] It will increase.
- [ ] It will have no impact.
> **Explanation:** If a company's marketable securities increase, the ratio will likely increase, as these are part of the liquid assets considered in the calculation.
### What should management do if the acid-test ratio is below 1?
- [ ] Increase inventory.
- [x] Increase liquid assets or decrease current liabilities.
- [ ] Reduce cash holdings.
- [ ] Expand fixed assets.
> **Explanation:** Management should look to increase liquid assets (such as cash or receivables) or decrease current liabilities to improve the ratio.
### Why is the acid-test ratio important for creditors?
- [ ] It measures profitability.
- [ ] It shows long-term growth potential.
- [x] It indicates the ability to pay off current debts.
- [ ] It assesses market position.
> **Explanation:** The acid-test ratio is important for creditors because it indicates the company's ability to pay off its current debts using its most liquid assets.
Thank you for exploring the vital concepts behind the acid-test ratio and engaging with our detailed sample quiz questions. Keep excelling in your financial understanding and applications!
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