An acid test ratio, also referred to as a quick ratio, measures a company’s ability to use its short-term assets to cover its immediate liabilities. This is more effective than the current ratio, as assets like inventory are ignored.
A standard liquid ratio of 1:1 is considered. If a company has a ratio lower than 1, its current liabilities cannot be fully paid back. With a quick 2.0 ratio, you have $2.00 of liquid assets to cover every $1.00 of current liabilities.
We include cash and cash equivalents, short-term marketable bonds, account receivables, and non-trade seller receivables to understand the company’s current liquid assets. The current liquid assets are then divided by the total current debts for calculating the acid test ratio.
The formula for Acid test ratio or Quick ratio is:
Acid Test = Cash+Marketable Securities+A/R / Current Liabilities
This article includes:
- Is a High Acid Test Ratio Good?
- How to improve the quick ratio?
- Interpretation of Quick Ratio / Acid Test Ratio
- What is an acceptable acid test ratio?
Is a High Acid Test Ratio Good?
A low or decreasing acid test ratio generally suggests that a company is struggling to maintain or grow sales, paying their bills too quickly, collecting receivables too slowly or over-leveraged.
On the other hand, a high or increasing acid test ratio indicates a company has faster inventory turnover and cash conversion cycles. This ratio happens when a company is experiencing top-line growth, quickly converting receivables into cash, and is easily able to cover its financial obligations.
How to improve the quick ratio?
Often the greatest organizations are faced with the greatest challenges pertaining to liquidity, to an extent where they are often forced to shut down.
Therefore, given the overall importance of ensuring liquidity within the firm, it is really rudimentary for organizations, regardless of their size to ensure that they follow certain protocols to improve their quick ratio.
Increasing Sales and Inventory Turnover:
There is no doubt to the fact that Sales and Inventory Turnover are some of the greatest determinants to gauge business standing.
However, in order to improve the liquid resources your business has in hand, it gets pivotal to increase the sales for your company. In return, this will increase inventory turnover.
Having greater turnover means greater cash in hand for the company, and hence, greater sales.
Improving Invoice Collection Period:
Long-term Debts extended to clients are often one of the biggest reasons for a company’s inability to meet its expenses. As a result, it often gets challenging to manage cash, and despite the fact that one might have greater sales and assets (long-term debtors), the liquidity position might get gruesome.
It also increases the company’s exposure towards risk, because the chance of clients defaulting on those debts gets higher, and significantly increases the probability of increased bad debts for the company.
Therefore, by giving long-debtors discounts in order to attract them to pay early, your organization can quickly convert long term assets into cash, thereby increasing the liquidity you have at your disposal.
Paying off liabilities quickly:
Current liabilities tend to have an inverse relationship with quick ratio, which should, therefore, be decreased. This can be achieved by ensuring that you are able to pay back liabilities in due time.
Discarding unproductive assets:
Often in an organization, the corporation has certain assets lined up which do not generate any considerable revenue for the company. These assets need to be identified and then discarded in order to get cash against those assets. This cash can then be taken for short term liquidity of the company, hence improving the quick ratio of the company.
As far as drawings are concerned, it can be seen that drawings from business owners should also be prioritized and kept at a minimum. If your business is a partnership, then there should be strict preventions to ensure that there are no withdrawals in the form of drawings, because that just takes a heavy toll on the existing cash in the company.
Interpretation of Quick Ratio / Acid Test Ratio
Quick ratio evaluates a company’s liquidity by comparing its cash plus almost cash current assets with its entire current financial obligations. It assists in verifying if the business or company has the capacity to pay off its current liabilities by means of the most liquid assets.
A firm with a quick-or-acid-test-ratio of 1:1 is considered to have sufficient liquidity. It is fit enough to pay off all the liabilities/bills on time. Consequently, it might be said that, for the most part, a higher quick ratio is best in light of the fact that it implies more noteworthy liquidity.
However, a ratio of 4:1 is not good for a business as this implies that the business has 4 times idle current assets against the requirement of 1. These idle assets could have been utilized to make extra money consequently contributing to net profits. Put differently, an exceedingly high rate of the quick ratio may point out incompetence in financial management.
An excellent authority is to locate an industry standard and then contrast the current and acid test ratios of the business alongside this industry average.
What is an acceptable acid test ratio?
Although the acceptable acid test ratio range is dependent on industry, usually, an acid test ratio of 1:1 is considered normal. In most cases, a ratio of <1 is not considered an acceptable acid test ratio, as it indicates that the company will not be able to pay back its current liabilities in full. Generally, a high acid test ratio is a strong indication of financial health. However, it may also signal that your business is too conservative when it comes to capital allocation.