What is the acid-test ratio?

The acid-test ratio, also known as the quick ratio, is an indicator of a company’s short-term liquidity that measures whether it has enough short-term assets to cover its short-term liabilities.

Widely thought of as a more conservative metric, unlike the working capital ratio, it does not include assets that cannot be quickly liquidated, such as inventory.

Acid-test ratio formula

There is no absolute method for determining a company’s acid-test ratio, as no two companies are the same. In such instances and industries where accounts receivable take much longer to recoup than normal, they should not be included. Technical assets such as payments in advance and deferred tax assets should also be disregarded.

The lower the ratio result, the worse the company’s liquidity and the greater the likelihood that it will be unable to pay its debts. The higher the result, the greater the firm’s financial stability.

Another acid test ratio example formula

The ratio’s supporters argue that by disregarding inventory, it provides a more accurate insight into the immediate strength of a business than the current ratio.

A large inventory could overstate a company’s strength, resulting in poor decision-making in the future. Furthermore, for companies whose inventories fluctuate depending on the seasons, the metric can paint a more consistent image of their fundamentals.

Detractors have criticised the acid-test ratio for not adequately factoring in the level and timing of cash flows, assessing instead an immediate snapshot.