Acid-Test Ratio

Published Jan 22, 2023

Definition of Acid-Test Ratio

The acid-test ratio, also known as the quick ratio, is a measure of a company’s liquidity. That means it measures a company’s ability to cover its short-term liabilities. It is calculated by dividing the sum of a company’s cash, marketable securities, and accounts receivable by its current liabilities. The higher the ratio, the more liquid the company is. In most cases, the ratio should exceed a value of 1 to indicate sufficient liquidity.

Example

Let’s look at an example to illustrate the acid-test ratio. Assume a company has USD 100,000 in cash, USD 50,000 in marketable securities, and USD 25,000 in accounts receivable. In addition to that, the company has USD 150,000 in current liabilities. 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.

Why Acid-Test Ratio Matters

The acid-test ratio is an important measure of a company’s liquidity. It helps investors and creditors to assess the company’s ability to pay its short-term obligations. A high ratio indicates that the company has enough liquid assets to cover its current liabilities. On the other hand, a low ratio indicates that the company may not be able to pay its short-term obligations and may be in financial distress. Thus, the acid-test ratio is an important tool to assess the financial health of a company.