Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early miners.
In most cases, the ratio should exceed a value of 1 to indicate sufficient liquidity. Both the current ratio, also known as the working capital ratio, and the acid-test ratio measure a company’s short-term ability to generate enough cash to pay off all debts should they become due at once. However, the acid-test ratio is considered more conservative than the current ratio because its calculation ignores items https://www.wave-accounting.net/ such as inventory, which may be difficult to liquidate quickly. Another key difference is that the acid-test ratio includes only assets that can be converted to cash within 90 days or less, while the current ratio includes those that can be converted to cash within one year. The quick ratio or acid test ratio is a measure of liquidity that measures a company’s ability to pay off its existing liabilities.
- Quick ratio establishes a timeframe and places restrictions on the number of assets that can be included in calculations.
- For example, the retail industry has a quick ratio value that is substantially lower than its current ratio.
- If metal failed the acid test by corroding from the acid, it was a base metal and of no value.
- The current ratio measures a company’s ability to pay current, or short-term, liabilities (debt and payables) with its current, or short-term, assets (cash, inventory, and receivables).
You can calculate a business’ acid test ratio by looking at its balance sheet, identifying the combined balance of all its quick assets, and dividing this combined quick asset balance by the balance of all its current liabilities. Assume a company has USD 100,000 in cash, USD 50,000 in marketable securities, and USD 25,000 in accounts receivable. To calculate the acid-test ratio, we divide the sum of the company’s cash, marketable securities, and accounts receivable (i.e., 175,000) by its current liabilities (i.e., 150,000). That gives us an acid-test ratio of 1.17, which indicates that the company has enough liquidity to cover its short-term liabilities.
Acid-Test Ratio: Definition, Formula, and Example
The ratio’s denominator should include all current liabilities, debts, and obligations due within one year. If a company’s accounts payable are nearly due but its receivables won’t come in for months, it could be on much shakier ground than its ratio would indicate. The acid-test ratio, commonly known as the quick ratio, uses data from a firm’s balance sheet to indicate whether it has the means to cover its short-term liabilities. Generally, a ratio of 1.0 or more indicates a company can pay its short-term obligations, while a ratio of less than 1.0 indicates it might struggle to pay them. The current ratio does not inform companies of items that may be difficult to liquidate.
When should you use the quick ratio?
Consider a company with $1 million of current assets, 85% of which is tied up in inventory. Both the current ratio and quick ratio measure a company’s short-term liquidity, or its ability to generate enough cash to pay off all debts should they become due at once. Although they’re both measures of a company’s financial health, they’re slightly different.
What is the quick ratio rule of thumb?
Inventory that takes a long time to convert into sales is useless to meet emergency obligations. At a quick glance, acid-test ratios are a measure of a firm’s capability to stay afloat and a function of its ability to quickly generate cash during times of stress. An acid-test ratio of less than one is a strike against a firm because it translates to an inability to pay off creditors due to fewer assets than liabilities.
Quick assets for this purpose include cash, marketable securities, and good debtors only. In other words, prepaid expenses and inventories are not included in quick assets because there may be doubts about the quick liquidity of inventory. In the example above, the quick ratio of 1.19 shows that GHI Company has enough current assets to cover its current liabilities. For every $1 of current liability, the company has $1.19 of quick assets to pay for it. The quick ratio is the barometer of a company’s capability and inability to pay its current obligations. Investors, suppliers, and lenders are more interested to know if a business has more than enough cash to pay its short-term liabilities rather than when it does not.
Inventory is deducted from the overall figure for current assets, leading to a low figure for the numerator and, therefore, low acid-test ratio figures. Apple, which had high cash figures on its balance sheet under then-CEO Steve Jobs, was an example. The acid-test ratio and current ratio are two frequently used metrics to measure near-term liquidity risk, or a company’s ability to quickly pay off liabilities coming due in the next twelve months. Some may consider the quick ratio better than the current ratio because it is more conservative. The quick ratio demonstrates the immediate amount of money a company has to pay its current bills. The current ratio may overstate a company’s ability to cover short-term liabilities as a company may find difficulty in quickly liquidating all inventory, for example.
What You Need to Calculate the Acid-Test Ratio
Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. For example, Walmart, Target, and Costco are big retailers who can negotiate favorable supplier terms that do not require them to pay their vendors immediately or based on norms in the industry. Even within the retail industry, the level of inventory holdings can vary based on the retailer size. A figure of 0.26 means that ABC does not have sufficient assets to liquidate, if its creditors come calling. Technology companies are another case in point because they have low fixed inventory numbers. As you can see, the ratio is clearly designed to assess companies where short-term liquidity is an important factor.
Accounts receivable are generally included, but this is not appropriate for every industry. Since the current ratio includes inventory, it will be high for companies that are heavily involved in selling inventory. For example, in the retail industry, a store might stock up on merchandise leading up to the holidays, boosting its current ratio.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days. Marketable securities are traded on an open market with a known price and readily available buyers. Any stock on the New York Stock Exchange would be considered a marketable security because they can easily be sold to any investor when the market is open.
As one would reasonably expect, the value of the acid-test ratio will be a lower figure since fewer assets are included in the numerator. Hence, the acid-test ratio is more conservative in terms of what is classified as a current asset in the formula. The optimal acid-test ratio number for a specific company depends on the industry and marketplaces the company operates in, the exact nature of the company’s business, and the company’s overall financial stability.
A company with a low current or quick ratio should likely proceed with some degree of caution, and the next step would be to determine how much more capital and how quickly it could be obtained. In particular, a current ratio below 1.0x would be more concerning than a quick ratio below 1.0x, although either ratio being low could be a sign that liquidity might soon become a concern. Most often, companies may not face imminent capital constraints, or they competitor audit template may be able to raise investment funds to meet certain requirements without having to tap operational funds. Therefore, the current ratio may more reasonably demonstrate what resources are available over the subsequent year compared to the upcoming 12 months of liabilities. At the other extreme, an acid test ratio that is too high could indicate that a company is holding on too tightly to its cash when it could be using it to fuel business growth.
When analyzing a company’s liquidity, no single ratio will suffice in every circumstance. It’s important to include other financial ratios in your analysis, including both the current ratio and the quick ratio, as well as others. More importantly, it’s critical to understand what areas of a company’s financials the ratios are excluding or including to understand what the ratio is telling you.
If metal failed the acid test by corroding from the acid, it was a base metal and of no value. For example, inventories may take several months to sell; also, prepaid expenses only serve to offset otherwise necessary expenditures as time elapses. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. As discussed earlier, acid-test ratios for the retail industry tend to be lower than average mainly because the industry tends to hold more inventory as compared to others.