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.
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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
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)/
current liabilities
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.
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