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They say cash is king. Without cash or assets that can be easily converted to cash, businesses may find it challenging to pay off their current debts. The acid test ratio measures how easy it is for businesses to meet their short-term obligations using cash and by selling off liquid assets.
A company may have lots of assets, but with no easy way of converting those to cash it will be difficult to cover short-term debts if they became due immediately. There are two ratios that can be used to determine this, namely: the acid test ratio and the working capital ratio.
While both ratios are very popular among financial analysis, the acid test is more stringent in that it excludes inventory, as a current asset, in calculating the ratio. Investors, and creditors in particularly, are most interested in applying this stringent measure of a company’s ability to easily pay off current liabilities because if creditors become demanding and unreasonable, the company may be forced to take extreme measures to satisfy their demands.
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How to Calculate the Acid Test Ratio
The acid test ratio is sometimes referred to as the quick ratio or the liquid ratio but the principle behind their calculation and interpretation is generally the same. The formula for calculating the Acid Test Ratio is:
(Cash + Short term investments +Accounts receivables) /Current Liabilities
An alternative formula for calculating the quick/acid test/liquid ratio is as follows:
(Current Assets – Stock)/ Current Liabilities
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How to Interpret the Acid Test Ratio
A ratio of 2:1 means that the business has $2 in cash and near cash assets for every dollar of current liability. On the other hand, if the ratio is below 1:1 the company won’t be able to repay current liabilities from what cash or cash equivalents it has on hand. This doesn’t signal the end of the world for the company though as brisk sales and cash from a loan can really prop up this figure. However, in an environment where sales are sluggish and long-term financing is hard to come by, the acid test can really signal that there could be trouble if creditors become restless.
The possibility that a company may have difficulty in converting inventory into cash is one reason that inventory is kept out of the formula. The working capital ratio on the other hand has no such prejudice, in that it assumes that the business will continue to generate cash from sales to meet obligations.
However, if the working capital ratio is significantly higher than the acid test ratio, this is a clear sign that the business has a high percentage of its current assets in inventory, which is the norm for retailers. To further analyze this situation the analyst may want to have a look at the inventory turn ratio to see how quickly the company is moving inventory out the door.
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While in many instances inventory is being converted to cash through brisk sales, business analyst will need to determine just how easily a business can meet its obligations with cash and cash equivalents alone. This gives an indication as to whether the business can pay off current liabilities without trying to get cash from elsewhere, including taking a loan.