How to Use the Acid Test Ratio Liquidity Metric
Companies use the acid test ratio (aka quick ratio) metric to determine whether they would be able to pay off their debts due within the next year. Some companies that sell very large or expensive items have a difficult time selling inventories.
The acid test ratio uses all current assets except inventories and divides their value by the current liabilities, as you can see in the equation that follows:
Follow these steps to put this equation to work:
Add together the company’s cash equivalents, marketable securities, and accounts receivables.
Divide the answer from Step 2 by the value of the current liabilities to get the acid test ratio.
This ratio shows how many times a company could pay off the debt that’s due within the next 12 months using current assets other than inventory.
Because this value doesn’t include inventories, it’ll be smaller than the current ratio, but it’s still important to consider because it shows whether a company has enough cash and other assets to quickly turn into cash to pay off debts owed and avoid bankruptcy.
Even so, a low acid test ratio may mean the company is at risk, or it may mean that the company is very effective at managing its accounts receivables by collecting them very quickly. The moral of the story: Be sure to interpret this ratio in the context of the company’s receivables management.