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Acid-Test Ratio Learn How to Calculate the Acid-Test Ratio

Because inventory levels vary widely across industries, in theory, this ratio should give us a better reading of a company’s liquidity than the current ratio. Using our ABC Company example (with inventory of say $29m), the acid-test ratio would be 100,000,000 minus 29,000,000 divided by 67,000,000 to equal 1.06 or 106%. This figure means that, for every dollar of current liabilities, the company has $1.06 of easily convertible assets.

The ratio displays, on the balance sheet of a corporation, the
value of the assets that may be converted into cash within a period of one year. The quick ratio or acid test ratio formula is all about finding your liquid assets, which is done by subtracting your inventory and prepaids from your current assets. So while inventory typically falls under current assets, you need to separate them for this formula because we’re only interested in your most liquid assets, like cash. The formula to calculate the current ratio divides a company’s current assets by its current liabilities. While the high inventory balance and growth benefit the current ratio, the quick ratio excludes illiquid current assets such as inventory. The gap between the current ratio and quick ratio stems from the inventory line item, which comprises a significant portion of the total current assets balance.

However, because the current ratio at any one time is just a snapshot, it is usually not a complete representation of a company’s short-term liquidity or longer-term solvency. The acid test ratio is a way of measuring a firm’s liquidity by looking at the company’s
current assets and ignoring its inventory of the company. To determine it, start by
taking current assets and removing inventory from the total, then divide that number by
current liabilities. The current ratio is a less conservative measure than the acid-test ratio, because it includes inventory. When the inventory owned by a business takes a long time to liquidate, the current ratio can be misleading, because it assumes that the inventory can be readily converted into cash.

How to Calculate (And Interpret) The Current Ratio

You can find them on your company’s balance sheet, alongside all of your other liabilities. Here, we’ll go over how to calculate the current ratio and how it compares to some other financial ratios. Baremetrics monitors your SaaS quick ratio, computing everything from your company’s MRR as shown by your membership or subscription payments/upgrades as well as monthly churn rates. Integrating this innovative tool can make financial analysis seamless for your SaaS company, and you can start a free trial today.

AccountingCoach PRO has 24 blank forms to guide you in calculating and understanding financial ratios. Accounting ratios such as the current ratio and the quick ratio can also help you quickly identify trouble spots and if your business is headed in the wrong direction. The results of these ratios may also be helpful when creating financial projections for your business. The Acid Test or Quick Ratio measures the ability of a company to use its assets to retire its current liabilities immediately.

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. The only assets applied during this calculation programs that limit are those kinds of assets that can be converted to cash within 90 days. The assets, in addition to cash and cash equivalents, include marketable investments and accounts receivable, which are the liquid assets accessible within 90 days of the analysis. To calculate the current ratio, current assets are divided by current liabilities.

  • Current liabilities used to calculate the acid test ratio include accounts payable, short-term debts and other debts as well as accrued liabilities.
  • However, it isn’t enough to glance at the table and decide the company is growing; the exact value of your SaaS quick ratio can mean different things.
  • In Year 1, the current ratio can be calculated by dividing the sum of the liquid assets by the 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.
  • Here, the company could withstand a liquidity shortfall if providers of debt financing see the core operations are intact and still capable of generating consistent cash flows at high margins.

As a result, you could have a good current ratio but struggle to meet your short-term obligations. In comparison to the current ratio, the quick ratio is considered a more strict variation due to filtering out current assets that are not actually liquid — i.e. cannot be sold for cash immediately. Otherwise referred to as the “acid test” ratio, the quick ratio’s distinction from the current ratio is that a more stringent criterion is applied for the current assets included in the calculation. In addition, a company such as Apple that has been extremely successful and building up its cash positions and current assets will have a solid and strong current ratio throughout the years.

What is Acid Test Ratio?

These calculations are fairly advanced, and you probably won’t need to perform them for your business, but if you’re curious, you can read more about the current cash debt coverage ratio and the CCC. Your ability to pay them is called “liquidity,” and liquidity is one of the first things that accountants and investors will look at when assessing the health of your business. This ratio is used to measure a company’s capacity to maintain operations as normal using current cash or near cash reserves in bad periods.

A good current ratio is 2, indicating you have twice as much in assets as liabilities. After reading this section, you will have been exposed to the different types of liquidity ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm’s activities. Large companies may have inventory lying in warehouses across the globe or may deal with human error when counting. Inventory calculation could be greater or less than it really is, and as previously stated, could be manipulated to overinflate the current ratio.

What is the difference between the current ratio and the quick ratio?

The inventory balance of our company expanded from $80m in Year 1 to $155m in Year 4, reflecting an increase of $75m. In fact, such a company may be viewed favorably by the equity or debt capital markets and be able to raise capital easily. Of course, the choice to use accounting software can also play a role in the reporting process, automating the bookkeeping and accounting process, while ensuring the financial statements you produce are accurate. This value is over 1.0, indicating that Tesla has decent liquidity and should be able to cover its short-term obligations. It could indicate that cash has accumulated and is idle rather than being reinvested, returned to shareholders, or otherwise put to productive use. Amanda Bellucco-Chatham is an editor, writer, and fact-checker with years of experience researching personal finance topics.

What Are the Limitations of the Current Ratio?

Our company’s current ratio of 1.3x is not necessarily positive, since a range of 1.5x to 3.0x is usually ideal, but it is certainly less alarming than a quick ratio of 0.5x. The quick ratio compares the short-term assets of a company to its short-term liabilities to determine if the company would have adequate cash to pay off its short-term liabilities. It’s recommended a quick ratio be at least 1, indicating that for every dollar you have in liabilities, you have $1 in assets. If comparing your quick ratio to other companies, only compare to businesses in your industry.

Other liquidity ratios, while different in theory, largely have the same drawbacks. Ideally companies want a current ratio of over 1.50, preferably as high as 2.0 to provide a significant liquidity cushion. Apple’s current ratio of 1.54 is quite solid and shows that there are more than enough current assets to cover current liabilities. If the ratio was down near 1.0, it would indicate that the company may have issues meeting short-term obligations, and that they may have issues paying off these obligations in the near future. In other words, the current ratio is a good indicator of your company’s ability to cover all of your pressing debt obligations with the cash and short-term assets you have on hand.

A high current ratio, on the other hand, may indicate inefficient use of assets, or a company that’s hanging on to excess cash instead of reinvesting it in growing the business. These are future expenses that have been paid in advance that haven’t yet been used up or expired. Generally, prepaid expenses that will be used up within one year are initially reported on the balance sheet as a current asset.

What Happens If the Current Ratio Is Less Than 1?

Therefore, the higher the ratio, the better the short-term liquidity health of the company. As one would reasonably expect, the value of the acid-test ratio will be a lower figure since fewer assets are included in the numerator. More detailed analysis of all major payables and receivables in line with market sentiments and adjusting input data accordingly shall give more sensible outcomes which shall give actionable insights.

Quick Ratio Calculation Example

However, the quick ratio formula provided is generic and applies in several industries, but the variables computed are different when it comes to the SaaS industry. For very good reason, you will find that the most talked about financial ratio is the quick ratio. It’s quick, easily calculable, and an executive cannot make a wrong decision by applying only the quick ratio.

The current ratio uses all of the current assets and divides their total by the total amount of current liabilities. The current liabilities include all debts and obligations that are to be settled within one year. Short-term debt, accounts payable, and other accrued debts and liabilities are examples of current liabilities. True to its name, the quick ratio is a financial analysis metric that is quick to calculate because it does not contain as many variables as, e.g., the current ratio in its calculation.