Acid-Test Ratio: Definition, Formula, and Example
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What Is the Acid-Test Ratio?
The acid-test ratio is commonly known as the quick ratio. It uses data from a firm’s balance sheet to indicate whether it has the means to cover its short-term liabilities. A ratio of 1.0 or more generally indicates that a company can pay its short-term obligations. A ratio of less than 1.0 indicates that it might struggle to pay them.
Key Takeaways
- The acid-test ratio or quick ratio helps to show whether a company can quickly pay off its short-term debts using its most liquid assets.
- A ratio above 1.0 is generally a good sign.
- This ratio is more conservative than the current ratio because it leaves out inventory and other assets that aren’t easily converted into cash.
- A high acid-test ratio isn’t always great because it might mean that a company is sitting on too much idle cash rather than putting it to work.
Investopedia / Joules Garcia
Understanding the Acid-Test Ratio
Analysts prefer to use the acid-test ratio rather than the current ratio, also known as the working capital ratio, in certain situations because the acid-test method ignores assets such as inventory that may be difficult to liquidate quickly. The acid-test ratio is a more conservative metric.
Companies with an acid-test ratio of less than 1.0 don’t have enough liquid assets to pay their current liabilities and they should therefore be treated cautiously. A company’s current assets are highly dependent on inventory if the acid-test ratio is much lower than the current ratio.
This isn’t a bad sign in all cases, however, because some business models are inherently dependent on inventory. Retail stores might have very low acid-test ratios without necessarily being in danger. The acceptable range for an acid-test ratio will vary among industries and you’ll find that comparisons are most meaningful when you’re analyzing peer companies in the same industry.
The acid-test ratio for most industries should exceed 1.0 but a high ratio isn’t always good. It could indicate that cash has accumulated and is sitting idle rather than being reinvested, returned to shareholders, or otherwise put to productive use.
Important
Some tech companies generate massive cash flows and therefore have acid-test ratios as high as 7 or 8. This is certainly better than the alternative but these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits.
Calculating the Acid-Test Ratio
The numerator of the acid-test ratio can be defined in various ways but the primary consideration should be gaining a realistic view of the company’s liquid assets. Cash and cash equivalents should be included as well as short-term investments such as marketable securities.
Accounts receivable are generally included but this isn’t appropriate for every industry. Accounts receivable in the construction industry may take much more time to recover than is standard practice in other industries so including it could make a firm’s financial position seem much more secure than it is in reality.
The formula is:
Acid Test=Current LiabilitiesCash+Marketable Securities+A/Rwhere:A/R=Accounts receivable
Another way to calculate the numerator is to take all current assets and subtract illiquid assets. Most importantly, inventory should be subtracted. This will negatively skew the picture for retail businesses because of the amount of inventory they carry.
Other elements that appear as assets on a balance sheet should be subtracted if they can’t be used to cover liabilities in the short term. These can include advances to suppliers, prepayments, and deferred tax assets.
The ratio’s denominator should include all current liabilities, debts, and obligations due within one year. It’s important to note that time isn’t factored into the acid-test ratio. A company could be on much shakier ground than its ratio would indicate if its accounts payable are nearly due but its receivables won’t come in for months, The opposite can also be true.
Fast Fact
The term “acid-test” is rumored to have originated from testing precious metals like gold with acid to make sure they were real.
Example of the Acid-Test Ratio
A company’s acid-test ratio can be calculated using its balance sheet. This is an abbreviated version of Apple Inc.’s (AAPL) balance sheet as of Jan. 27, 2022, showing the components of the company’s current assets and current liabilities. All figures are in millions of dollars:
| Cash and cash equivalents | 37,119 |
| Short-term marketable securities | 26,794 |
| Accounts receivable | 30,213 |
| Inventories | 5,876 |
| Vendor non-trade receivables | 35,040 |
| Other current assets | 18,112 |
| Total current assets | 153,154 |
| Accounts payable | 74,362 |
| Other current liabilities | 49,167 |
| Deferred revenue | 7,876 |
| Commercial paper | 5,000 |
| Term debt | 11,169 |
| Total current liabilities | 147,574 |
To obtain the company’s liquid current assets, add:
- Cash and cash equivalents
- Short-term marketable securities
- Accounts receivable
- Vendor non-trade receivables
To get current liabilities, add:
- Accounts payable
- Other current liabilities
Then divide current liquid assets by current liabilities to calculate the acid-test ratio. The calculation would look like this:
Apple’s ATR = ($37,119 + $26,794 + $30,213 + $35,040) / ($74,632 + $49,167) = 1.04
Not everyone calculates this ratio in the same way. There’s no single, hard-and-fast method for determining a company’s acid-test ratio. Some analysts might include other balance sheet line items that aren’t included in this example. Others might remove the ones we’ve used here. It’s therefore important to understand how data providers arrive at their conclusions before using the metrics that are given to you.
What’s the Difference Between the Current and the Acid-Test Ratios?
The current ratio, also known as the working capital ratio, and the acid-test ratio both measure a company’s short-term ability to generate enough cash to pay off all its debts should they become due at once.
The acid-test ratio is considered more conservative than the current ratio, however, because its calculation ignores items 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. The current ratio includes those that can be converted to cash within one year.
What Does the Acid-Test Ratio Tell You?
The acid-test or quick ratio shows if a company has or can get enough cash to pay its immediate liabilities, such as short-term debt. The acid-test ratio for most industries should exceed 1.0. Companies don’t have enough liquid assets to pay their current liabilities if it’s less than 1.0 and they should therefore be treated with caution.
A company’s current assets are highly dependent on inventory if the acid-test ratio is much lower than the current ratio. However, a very high ratio could indicate that accumulated cash is sitting idle rather than being reinvested, returned to shareholders, or otherwise put to productive use.
How Do You Calculate the Acid-Test Ratio?
Divide a company’s current cash, marketable securities, and total accounts receivable by its current liabilities. This information can be found on the company’s balance sheet.
The Bottom Line
The acid-test ratio, also called the quick ratio, is a metric that’s used to determine whether a company is positioned to sell assets within 90 days to meet immediate expenses. Analysts generally believe that a business can pay its immediate expenses if the ratio is more than 1.0. It can’t do so if it’s less than 1.0.
The reliability of this ratio depends on the industry of the business you’re evaluating so it’s best to use it when comparing similar companies.
Correction—Nov. 8, 2023: A previous version of this article stated that to calculate current liabilities, you have to add accounts payable and other current assets, when it’s actually other current liabilities.
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