Quick Ratio or Acid Test Ratio Formula, Calculation, & Example

In Year 1, the current ratio can be calculated by dividing the sum of the liquid assets by the current liabilities. 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. A cash flow budget is a more accurate tool to assess the company’s debt commitments. While figures of one or more are considered healthy for quick ratios, they also vary based on sectors. The steps to calculate the two metrics are similar, although the noteworthy difference is that illiquid current assets — e.g. inventory — are excluded in the acid-test ratio. When analyzing Financial Statements, it is very important to use the correct Financial Ratios.

Analysis

The current ratio, for instance, measures a company’s ability to pay short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The acid-test ratio is more conservative than the current ratio because it doesn’t include inventory, which may take longer to liquidate. This ratio is also known as the quick ratio because its numerator consists of a business’ “quick” assets—that is, its assets that are most readily available to pay down debt. Cash is obviously immediately available, and, of all other current assets, marketable securities and accounts receivable are the next most readily available, in theory. These are subtracted from current assets to arrive at quick assets, which are divided by current liabilities to get the acid-test ratio. Thus, the quick ratio attempts to measure the firm’s immediate debt-paying ability.

I say “theoretically” because, in practice, the acid-test ratio doesn’t consider the exact timing that the payments are owed, so it will always be just a high-level approximation. Generally speaking, anything above 1.0 is considered a “good” ratio, while anything below 1.0 would start to raise concerns. Inventory figures and other expenses, such as prepaid expenses incurred due to discounts offered on final products, are generally deducted from current assets. Quick ratios are useful only when they are compared to industry standards or trends for that sector.

Next, we apply the acid-test ratio formula in the same period, which excludes inventory, as mentioned earlier. Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.

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At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Even within the retail industry, the level of inventory holdings can vary based on the retailer size. They may include savings account holdings, term deposits with a maturity of fewer than three months and treasury bills. Therefore, it is not a really useful metric to determine whether the company can stay afloat, if and when its creditors come calling. It could indicate that cash has accumulated and is idle rather than being reinvested, returned to shareholders, present value annuity factor or otherwise put to productive use.

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. When he’s not working, he enjoys playing basketball, taking his kids to Disneyland, and discovering new hot sauces to enjoy. After all, isn’t inventory also an asset that is typically converted into cash within one year?

Quick Ratio or Acid Test Ratio FAQs

While usually accurate, this approximation does not always represent the total liquidity of the firm. The higher the ratio, the better the company’s liquidity and overall financial health. A ratio of 2 implies that the company owns $2 of liquid assets to cover each $1 of current liabilities. A very high ratio may also indicate that the company’s accounts receivables are excessively high – and that may indicate collection problems. The acid test ratio measures the liquidity of a company by showing its ability to pay off its current liabilities with quick assets.

It is calculated by dividing current assets that can be converted into cash in one year, by all current liabilities. The Acid-Test Ratio, also known as the quick ratio, is a liquidity ratio that measures how sufficient a company’s short-term assets are to cover its current liabilities. In other words, the acid-test ratio is a measure of how well a company can satisfy its short-term (current) financial obligations. This guide will break down how to calculate the ratio step by step, and discuss its implications. The quick ratio provides a stricter test of liquidity compared to the current ratio.

1. Therefore, the higher the acid-test ratio, the better the short-term liquidity health of the company.
2. We hold substantial inventory, but we know that with consumer trends always changing, it is not always easy to quickly sell off our inventory—at least, not without providing steep discounts.
3. The “floor” for both the quick ratio and current ratio is 1.0x, however, that reflects the bare minimum, not the ideal target.
4. These are subtracted from current assets to arrive at quick assets, which are divided by current liabilities to get the acid-test ratio.
5. The reliability of this ratio depends on the industry the business you’re evaluating operates in, so like many other financial ratios, it’s best to use it when comparing similar companies.

Boost your confidence and master accounting skills effortlessly with CFI’s expert-led courses! Choose CFI for unparalleled industry expertise and hands-on learning that prepares you for real-world success. Certain tech companies may have high acid-test ratios, which is not necessarily a negative, but instead indicates that they have a great deal of cash on hand. The reason for this is that inventories are not always easy to convert into cash. Someone on our team will connect you with a financial professional in our network holding the correct designation and expertise.

In this article, we will examine this helpful metric and explain how it can be an easy way to quickly gauge a company’s health. At the same time, we will also consider the limitations of this metric, and discuss why it needs to be interpreted carefully. For purposes of calculation, you only include securities that can be made liquid immediately or within the next year or so. The Acid-Test Ratio is calculated as a sum of all assets minus inventories divided by current liabilities. Companies can take steps to improve their quick ratios by either reducing their liabilities or boosting their asset count.

Quick Ratio: Definition

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. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets. The acid test ratio is similar to the current ratio in that it is a test of a company’s short-term liquidity.

The quick asset includes cash and short-term investments such as marketable securities, bench accounting @benchaccounting Accounts Receivable, prepaid expenses and inventory (if any). Current assets include cash, Accounts Receivable, inventories and short-term investments. The acid-test ratio (ATR), also commonly known as the quick ratio, measures the liquidity of a company by calculating how well current assets can cover current liabilities. The quick ratio uses only the most liquid current assets that can be converted to cash in a short period of time. Higher quick ratios are more favorable for companies because it shows there are more quick assets than current liabilities.