Managing cash flow is an essential component of running a strong business. It's important for businesses to be able to pay their bills as they come due, and the best way to make sure they're in a position to do that is to have enough assets available.
The acid-test ratio is a strong indicator as to whether a company has enough short-term assets on hand to cover its immediate liabilities. Also known as the quick ratio, the acid-test ratio is a liquidity ratio that measures a company's ability to pay its current liabilities with its quick or current assets.
Importance of the acid-test ratio
The acid-test ratio gets its name from the historic use of acid to test metals for gold. If acid was applied to a metal and didn't corrode it, that meant it was real gold. However, if the metal failed the test, it was considered valueless.
Today, the acid-test ratio shows a company's ability to convert its assets into cash to satisfy its immediate liabilities. It also compares a company's level of quick assets -- current assets that can be converted to cash within 90 days -- to current liabilities.
If a company has enough quick assets to pay for its current liabilities, it can meet its obligations without having to sell off its long-term assets. This is important, because most businesses rely on their long-term assets to bring in additional revenue. Not only might selling these assets hurt a company's profitability, but it might serve as a red flag for investors.
Quick assets are an essential component of the acid-test ratio. Quick assets include cash and cash equivalents, short-term investments or marketable securities, and current accounts receivable.
Short-term investments and marketable securities are those that can be converted to cash easily. Most stocks trading on a major exchange are considered marketable securities because they're widely available to investors, and can be sold with ease.
Acid-test ratio formula
The acid-test ratio is calculated by taking a company's quick assets and dividing them by its current liabilities. The following formula is how most companies calculate the acid-test ratio:
(cash + cash equivalents + short-term investments +current receivables)/
Let's say a company has $200,000 in cash and cash equivalents, $100,000 in short-term investments, $100,000 in current receivables, and $300,000 in current liabilities. Add up the first three numbers and divide by the last, and its acid-test ratio would be 1.33.
If a company has an acid-test ratio of 1, it means that its quick assets equal its current assets. An acid-test ratio of 2, meanwhile, indicates that a company has double the amount of quick assets as it does current liabilities.
It's usually in a company's best interest to have a higher acid-test ratio, as it shows that it has more quick assets than immediate liabilities. In other words, a high acid-test ratio is a strong sign of a company's liquidity. This is important to investors and lenders alike.
However, an extremely high acid-test ratio is not necessarily a good thing for a company, either. A number that's too high could indicate that a company is not putting its cash or short-term assets to good use. If a company, for example, has $300,000 sitting in a cash account earning minimal interest, it means that money isn't being used to grow the business.
Investors might perceive an unusually high acid-test ratio as a negative thing. For this reason, it's important for companies to aim to strike a balance between having enough assets on hand to cover their immediate liabilities without erring too much on the side of caution.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center, in general, or this page, in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.