The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term.
In other words, the quick ratio is a measure of how well a company can meet its short-term financial liabilities. It is liquidity metric and can be calculated as follows:
(Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
The quick ratio can be calculated for quick assets only.
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. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base metal and of no value.
The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.
The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets within 90 days. If a firm has enough quick assets to cover its total current liabilities, the firm will be able to pay off its obligations without having to sell off any long-term or capital assets.
The acid-test ratio is a more conservative version of another well-known liquidity metric — the current ratio.
Although the two are similar, the Acid-Test ratio provides a more rigorous assessment of a company’s ability to pay its current liabilities. It does this by eliminating all but the most liquid of current assets from consideration. Inventory is the most notable exclusion because it is not as rapidly convertible to cash and is often sold on credit. Some analysts include inventory in the ratio, though, if it is more liquid than certain receivables.
To demonstrate, let’s assume this information was pulled from the balance sheet of our theoretical firm:
Using the primary quick ratio formula and the information above, we can calculate this company acid-test ratio as follows
($70,000+$20,000+$50,000) / $105,000 = 1,33
This means that for every dollar of this company’s current liabilities, the firm has $1.33 of very liquid assets to cover those immediate obligations.
Inventory is not considered, because company may need 3 or 6 months or even years to sell inventory.
Why it matters?
It is vital that a company have enough cash on hand to meet accounts payable, interest expenses, and other bills when they become due. The higher the ratio, the more financially secure a company is in the short term. A common rule of thumb is that companies with an acid-test or quick ratio of greater than 1.0 are sufficiently able to meet their short-term liabilities.
Low or decreasing acid- test ratios generally suggest that a company is over-leveraged. It is struggling to maintain or grow sales. Maybe it is paying bills too quickly or collecting receivables too slowly. Hence, a high or increasing acid-test ratio indicates that a company is experiencing solid growth. It is quickly converting receivables into cash, and easily able to cover its financial obligations. Such a company often has faster inventory turnover and cash conversion cycles.
Like the other measures, acid-test ratio does have its potential drawbacks. To begin, analysts commonly point out that it provides no information about the level and timing of cash flows. And are what really determine a company’s ability to pay liabilities when due.
Also, the formula presumes that a company would liquidate its current assets to pay current liabilities. That is not always realistic.
But this measurement can give you a solid and quick view in some company’s financial status.
It is important for investors to know if some company are able to pay its bills and credits.
Most businesses use their long-term assets to generate revenues. Selling off capital assets will not only hurt the company. But it will show investors that current operations aren’t making enough profits to pay off current liabilities.
Higher quick ratios are more favorable for some company. It shows there are more quick assets than current liabilities.
A company with a quick ratio of 1 indicates that quick assets equal current assets. This also shows that the company could pay off its current liabilities without selling any long-term assets.
An acid ratio of 2 shows that the company has twice as many quick assets than current liabilities.
You see, as the ratio increases so do the liquidity of the company. More assets will be easily converted into cash if there is the need. This is a good sign for investors. Well, this is an even better sign for creditors. You know, creditors want to know they will be paid back on time.
One example more
Let’s assume some bakery is applying for a loan. The bank asks the owner for a detailed balance sheet, so it can compute the quick ratio. Bakery’s balance sheet includes the following accounts:
The bank can compute quick ratio like this.
($20,000+$7,000+$2,000) / $21,000 = 1,38
As you can see the bakery’s quick ratio is 1.38. This means that the owner can pay off all of the current liabilities with quick assets. And moreover, will have some quick assets left over.
For investors, it’s good news, too.
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What is the quick acid test ratio?
Quick ratio 1 shows about the company:
If the quick ratio is 1.38 that means: