The Fundamentals Of Acid-Test Ratio Explained

The acid-test ratio is a simple way to measure a company's short-term ability to generate enough cash to pay off all debts should they need to pay them at once. It is preferable to the current ratio as it excludes inventory which can be hard to liquidate.

What Is Acid-Test Ratio?

The acid-test ratio, also known as the quick ratio, is a method by which you can measure a company's liquidity by calculating whether the current assets can cover the current liabilities. Most of the assets you can use in this calculation are liquid assets can you can convert to cash within 90 days. Get details about lewis turning point.

Some of the vital points you have to remember in the case of the acid-test ratio is that-

• It assesses the company's balance sheet to check whether its current liquid assets can cover the existing debt.
• Having a ratio of 1 or more means that the company has enough cash to get out of debt.
• A low ratio can mean that the company has a shortage of cash or depends too much on inventory.
• Having a big ratio can mean that the company has a lot of excess cash. However, it can also be industry-specific in some cases.

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How To Calculate Acid-Test Ratio?

Calculating the acid-test ratio can be extremely simple as long as you have all the necessary information in front of you. To calculate the ratio, you need to add the cash and cash equivalents, current receivables, short term investments and divide the sum by the current liabilities. You should know about allocative efficiency.

Another way to calculate the numerator is to take all the current assets and subtract the illiquid ones. This is because these assets, especially inventory, cannot be liquified in a short amount of time and be used to pay off the debt. You can also subtract prepayments and deferred tax assets from the current assets.

No doubt calculating the acid-test ratio can go wrong in any step if you are not careful with the various numbers in the balance sheet. Have our experts proofread your assignment and avoid losing grades due to such minor errors.

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Acid-Test Ratio Formula

Having the acid-test ratio formula can be highly beneficial if you need to do some quick calculations. To calculate the ratio, you can use the formula:

Acid-test ratio = (cash + accounts receivables + short-term investments)/current liabilities

Or, Quick ratio = (Current assets – Inventory – Prepaid expenses) / Current liabilities

With the help of this formula, you can easily calculate the acid-test ratio and figure out if the company has the assets to pay off its debt immediately. If it is less than 1, the company does not have sufficient liquid assets to cover the current liabilities. If the ratio is more than 1, it means the company can quickly pay off their debt. Systematic sampling is a good option.

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Acid-Test Ratio Accounting

Maintaining a good amount of cash flow is vital in any business. This ensures that the company can pay their bills any time they are due and avoid more debt. The accounting department must always check on the acid-test ratio that acts as an excellent indicator of whether a company has enough short-term assets to cover any immediate liabilities. Know how to do pestle analysis.

The advantages of using acid-test ratio are:

• It is one of the fastest and easiest ways of measuring a company's liquidity.
• It is an inflexible method as it excludes assets like inventory and prepaid expenses that require more than a year to liquidate.

The disadvantages of using the acid-test ratio are:

• It excludes the time frame of payments.
• Excluding inventories can be a con for industries that depend primarily on inventories like the retail industry.
• You cannot use the acid-test ratio to compare different industries.

Checking this ratio, you can quickly figure out if the company is using its cash flow properly. Get information about money market.

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Frequently Asked Acid-Test Ratio Questions

Let's look at some of the common questions you will find in any acid-test ratio assignment.

1. Liquidity problems are likely to exist when a company's acid-test ratio is?

A common question that you'll have to face in your business assignments is- At which acid-test ratio is a company more likely to face liquidity problems?

The answer to this is simple. Any company will face liquidity problems if its acid-test ratio is substantially lower than 1:1. It translates into the fact that the company does not have enough liquid assets to pay off its debts and should therefore proceed cautiously. 

However, if the ratio is excessively low, it can indicate that the company is more dependent on inventories. For example, retail stores are always likely to have extremely low acid-test ratios as they are highly reliant on inventories.

2. Which of the following is included in the calculation of the quick (acid-test) ratio?

You can find all the information that you need to calculate the acid-test ratio in the company's balance sheet. This includes:

• Current assets or all assets that you can convert into cash in less than a year. This includes cash and cash equivalents, marketable securities and accounts receivable.
• Current liabilities, that is, a company's debt and obligations that are due within a year. This includes short-term debts, accounts payables and accrued liabilities and other debts.

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