How To Calculate Acid Test Ratio: Formula And Example
Consider you are a small manufacturer and are faced with leasing a warehouse for an extreme seasonal sale event. Due to short notice, the owner demands a high security deposit and excessive rent. Without proper warehousing, you may lose significant profits. At this juncture, you need to assess whether you can pay the rent and security without affecting your operations.
This is where the acid test ratios for business and investing, financial health, and liquidity of a company come into the picture. It measures the ability of a company to pay its short-term liabilities with the most liquid assets, including cash and equivalents, marketable securities, and receivables.
High quick ratios in industries like biotechnology and investment banking suggest strong financial positions that could support growth strategies or attract investors. Industries with low quick ratios may need to improve liquidity through better cash management or reduce reliance on inventory for short-term obligations.
This article provides a clear stepwise guide on how to compute the Acid Test liquidity metric, along with practical examples and explanations of its significance in assessing a company’s solvency.
Quick Ratio by Industry 2025
Quick ratios differ significantly from one industry to another. As per our recent studies, this ranges from 0.28 for the discount stores to 38.48 for the investment banks. Retail stores in the FMCG sectors, such as discount stores and food retailers, sell their inventory very fast, and hence, they can easily remain solvent even if it is less than 1.
While an ideal quick ratio is nearly one (1), it differs from one industry to another. As long as the quick ratio is within the industry benchmarks, the company is likely to avoid operational difficulties.
Calculating the Acid Test Ratio: Formula and Example
An alternative way to define the Acid test ratio is the ability of the company to meet its current obligations without using inventory or external financing. Companies or investors may use the acid test ratio as a more conservative measure of solvency when compared to the current ratio, which takes inventory into account.
Therefore, it can be expressed as:
Quick Ratio =Quick Assets/Current Liabilities…(i)
Where:
Quick Assets = Cash+Cash Equivalents+Marketable Securities+Account Receivables (Net)…..(ii)
Quick Ratio = Cash+Cash Equivalents+Marketable Securities+Account Receivables (Net)/Current Liabilities…(iii)
Let’s revisit our previous example with some data to explain how the acid test ratio can be useful. Consider the following balance sheet snapshot:
| Assets | |
|---|---|
| Cash & Equivalents | $22,750.00 |
| Marketable Securities | $10,000.00 |
| Accounts Receivables | $33,000.00 |
| Inventory | $150,000.00 |
| Liabilities | |
| Accounts Payables | $23,400.00 |
| Short Term Debt | $14,000.00 |
| Rent Due | $50,000.00 |
Identify and sum up the quick assets: From the above expression (ii), quick assets will include Cash & Equivalents, marketable securities, and account receivables. These will total to:
Quick Assets = $22,750+$10,000+$33,000 = $65,750
Identify and sum up the current liabilities: Current liabilities include Accounts payables and short-term debt. Here, we are not considering the rent payments initially because it is still in the decision-making phase.
Current Liabilities = $23,400+$14,000 = $37,400
Dividing Quick assets by liabilities: We get the acid test ratio using expression (i) as represented below:
Quick Ratio = $65,750/$37,400 = 1.76
Interpretation:
Initially, when there was no short-term rent liability, the calculated quick ratio was 1.76, indicating that the company could cover short-term liabilities 1.76 times. This may not be very high, but it is in the ideal range of 1-2. The ideal ratio will differ from industry to industry, but we have assumed this as an ideal industry.
Now, if the company has to rent out the warehouse, the ratio will be:
Quick Ratio = $65,750/$87,400 = 0.75
A ratio of 0.75 is less than the minimum level of acceptable ratio. This can surely create operational issues and may lead to loss of revenue. So, rather than risking the solvency of the company, it is likely better to operate with fewer sales and not rent out a warehouse.
Another option that could be explored is to search for a cheaper warehouse, even if it entails rising transport costs.
How does the quick ratio differ from the current ratio and cash ratio?
One of the most important assets that the quick ratio does not consider is inventory, whereas the current ratio will include it in its assets. Liquidating inventory can be tough at times and will again depend from one industry to another.
The cash ratio, on the other hand, is a more watered-down version of the quick ratio that only considers cash and cash equivalents. It does not consider marketable securities and receivables. Let’s see how all these three are related.
Current Ratio = Current Assets/Current Liabilities
If we take away inventories and prepaid expenses from the numerator, we get the Quick ratio.
Quick Ratio = Current Assets-Inventories-Prepaid Expenses/Current Liabilities
Further, taking away prepaid expenses, Marketable securities, and Accounts receivables, we have the cash ratio:
Cash Ratio = Current Assets-Inventories-Prepaid Expenses-Marketable Securities-Account Receivables/Current Liabilities
Now, since the only assets remaining are cash and cash equivalents, the cash ratio can also be represented as:
Cash Ratio = Cash and Cash Equivalents/Current Liabilities
Significance in assessing a company’s liquidity and financial health
The acid test ratio is a measure of solvency, thus helping different stakeholders with a quantifiable metric to make operational and investment decisions. Some of the major decision-making areas that it can help with are discussed here.
Assessment of Liquidity
The acid test ratio indicates the number of times the company can pay its liabilities using highly liquid short-term assets such as Cash & Equivalents, marketable securities, and account receivables.
A ratio of 1 indicates that the company will just meet its short-term liabilities and will remain solvent. Since it considers liabilities within a year, it is a measure of the short-term liquidity of the company.
Financial Health Indicator
A higher acid test ratio indicates financial health and liquidity of a company A ratio above 1 indicates that a company has liquid assets sufficient to meet its short-term obligations, reflecting strong financial health. Below 1 suggests potential liquidity challenges or over-reliance on inventory or other non-liquid assets.
Investment and lending decisions
Investors and lenders alike look for value within a company that will most likely protect their funding. Among other financial metrics, quick ratio is an important metric for the same.
For investors, it indicates the extent of cash inflows. Cash flows are one of the important metrics for investors for discounted valuations. Lenders, on the other hand, use a gamut of ratios starting from the current to quick and finally the cash ratio. Quick ratio, in conjunction with others, provides a measure of risk in the repayment of debt.
Strategic decision making
The acid test ratio comes in handy to assess if taking major business and investing decisions
may affect the stability of the company. Launching new products or entering new markets needs high capital requirements. This may affect the current assets even if outside funding is available.
The increase in sales may not keep with the increase in cash outflow for, say, raw materials. Mergers and acquisitions can change the balance sheet fundamentally, and ratios need to be appraised.
Industry benchmarking
Industry benchmarking involves using financial metrics to determine how companies in the industry fare. The acid test ratio ranges vastly from one industry to another. Industries in the FMCG sector, such as discount stores or food retailers, have ratios of 0.28 and 0.64, respectively.
A company with a quick ratio of less than 1 is not necessarily bad since turnovers might be higher. In such cases, a low quick ratio works because inventories are highly liquid.
Acid Test Ratio: Know your Business’s Financial pulse
The acid test ratio is one of the simplest measures to know the financial health and liquidity of a company. The calculation is not complex, and the data is straightforwardly available on the balance sheet. However, in its simplicity lies issues with its usage. It does not consider future cash flows that may become available in the near future, as was seen in the case of FMCG sectors.
Any liabilities later than 12 months are not considered, which may lead to a false sense of security. Marketable securities and accounts receivables may not realize their actual book value, and it can throw off planning based on the quick ratio.
Finding the right investor that would love to be a part of your startup can be challenging. Putting together a ratio analysis can be exhausting. This is where Eqvista’s panel of experts can help you with everything from modeling to your company’s valuation. Reach out to us with your needs or queries at the earliest here.
