An acid test ratio is a tool that gives an understanding of a company's ability to pay off its current liabilities.
An acid-test ratio compares a company's quick assets (cash, accounts receivable, etc.) with its current liabilities (short-term debts, account receivables, etc.) to analyze a company’s ability to pay off its current liabilities without relying on the option of obtaining additional financing. It not only helps the current stakeholders (including suppliers and lenders) but also the prospective investors to understand the company’s financial standing. Inventory is deducted while calculating the ratio, as it is not ordinarily an asset that can be converted into cash with ease in the short term. The acid-test ratio is considered a conservative estimation of a company’s financial health.
The formula for the acid-test ratio is:
Acid Test Ratio = (Total current assets - Inventory) / Total current liabilities
The figures from an acid test calculation reveal the health of a company and its ability to settle its current debts. The higher the ratio, the better the company’s liquidity and general financial health. A ratio of more than one implies that the company owns $2 of liquid assets to cover each $1 of current liabilities. But it’s important to communicate that a high ratio (for example, a ratio of 10) is not considered promising, as it indicates that cash is sitting idle, rather than being put to productive use.
On the other hand, a company with a ratio less than 1 would want to come up with more current assets. One way to do this is by offering discounts to boost sales, fulfilling its accounts receivables, or selling bonds to increase cash flow.
Ideally, a business should have a ratio of 1.
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