When assessing a company’s financial health, especially its ability to pay off short-term debts, one key metric is the Acid Test Ratio (also known as the Quick Ratio). This ratio helps answer a simple question: Can a company cover its immediate debts with cash and other assets easily converted into cash? This article will break down the acid test ratio, explain how to calculate it with examples, show how to interpret it, and give practical tips to improve it.
Table of Contents
What is the acid test ratio?
How can businesses calculate their acid test ratio?
How can businesses interpret their acid test ratio?
5 tips to help businesses improve their acid test ratio
Acid test ratio vs. current ratio: What’s the difference?
Wrapping up
What is the acid test ratio?
The acid test ratio helps businesses see if they can cover their short-term bills and debts without selling their inventory. It helps answer questions like, “If all sales stopped suddenly, can my business still pay its bills?”
But why does the acid test ratio not cover inventory? Inventory is not always easy to turn into cash. It could be items sitting on shelves or raw materials. What’s important is that selling them will take time—finding buyers is also not a guarantee. For this reason, the acid test ratio only focuses on assets that businesses can quickly convert into cash, making it a more cautious way to measure financial health.
Here are three “quick” assets businesses can use to measure their acid test ratio:
- Cash and cash equivalents (includes everything in the bank and liquid investments).
- Marketable securities (includes investments, like stocks or bonds, that owners can sell easily).
- Account receivables (includes money customers owe the business that should come in soon).
How can businesses calculate their acid test ratio?
Calculating the acid test ratio is easy when businesses have the formula. Here’s what they need to know before jumping into numbers.
Acid Test Ratio = Quick Assets (cash + marketable securities + account receivables) / Current Liabilities
The formula adds everything businesses can tap into during emergencies and divides it by their current short-term debt. Here’s an example to show this action. Imagine a company with the following financials:
- Cash: US$ 50,000
- Marketable securities: US$ 30,000
- Accounts receivable: US$ 40,000
- Current liabilities: US$ 100,000
The company can calculate its acid test ratio by summing up all its quick assets first, like in the example below:
US$ 50,000 (cash) + US$ 30,000 (marketable securities) + US$ 40,000 (account receivables) = US$ 120,000
Now that it has the amount of money it can tap into in a pinch, the company will now divide it by its current liabilities to get its acid test ratio:
US$ 120,000 / US$ 100,00 = 1.2
Acid test ratio = 1.2
How can businesses interpret their acid test ratio?
Now that businesses know how to calculate the ratio, how do they make sense of it? Here’s what they need to know after getting their numbers.
- A ratio greater than 1 means the company has more than enough liquid assets to cover its current liabilities. Such ratios are a good sign, as the company can pay its short-term debts without selling inventory or borrowing more money.
- A ratio equal to 1 means the company has just enough quick assets to cover its current liabilities. While it’s not necessarily bad, the business will have little wiggle room.
- A ratio of less than 1 is a red flag. The company doesn’t have enough liquid assets to cover its short-term debts, which could lead to cash flow problems or even financial trouble.
Industry-specific interpretations
While many consider a ratio of more than one a generally positive sign, what companies actually feel is a “good” ratio depends on their industry. For example, if the business is in retail or manufacturing, it will carry a lot of inventory.
So, it’s normal for such companies to have slightly lower acid test ratios. On the other hand, tech companies (which don’t usually hold many physical products) will often aim for higher ratios.
Note: A very high acid test ratio usually means the business has a lot of idle cash they could use for something better, like reinvestments, shareholder payments, or something more productive.
5 tips to help businesses improve their acid test ratio
Don’t panic if the company’s acid test ratio is less than ideal. Businesses can do several things to improve it. The basic idea is to increase their quick assets or reduce their current liabilities. So, here are five practical tips to help with that.
1. Boost cash reserves
A straightforward way to improve your acid test ratio is to increase the cash the business has. Here’s how they can do it:
- Increase sales: Although it’s easier said than done, boosting sales is a great way to bring more cash into the business directly.
- Cut costs: Businesses can also reduce expenses to help them hold on to more cash.
- Better cash flow management: They can also consider speeding up the customer payment process while extending the time they take to pay suppliers.
- Sell unused assets: If the company owns assets that aren’t critical to operations, consider selling them to raise quick cash.
2. Get paid faster (improve accounts receivable)
The quicker businesses can collect money customers owe them, the more cash they will have on hand. One way they can speed up collections is by shortening credit terms. For instance, businesses can consider reducing the time customers have to pay from 60 days to 30 days.
Additionally, they offer early payment discounts. If businesses give customers a small discount for paying their invoices early, it can encourage faster payments. Lastly, companies must remember to chase overdue payments by having systems to follow up on late payments. The quicker businesses collect, the better.
3. Reduce current liabilities
Another strategy is to focus on lowering the business’s current liabilities (bills they must pay in the short term). Companies can consider paying off short-term debts to improve their ratio immediately. Businesses can also try extending the payment deadlines with their suppliers. This can give them more time to gather cash while keeping the ratio healthier.
4. Trim down inventory
Since the acid test ratio doesn’t count inventory, having too much of it can hurt the business’s liquidity. Instead, retail and manufacturing companies should have just-in-time inventory systems. So, rather than stocking up on items that might sit on shelves for months, they will order only what they need when needed—it’s another effective way to free up cash.
But that’s not all. If businesses have excess inventory that’s hard to sell, they should offer discounts or clearance sales to help convert it into cash. Having idle inventory won’t help get a good ratio.
5. Refinance or restructure debt
If a business’s short-term debt makes its acid test ratio look bad, it should consider refinancing it into longer-term debt. While this shift won’t make the debt disappear, it will give the business more breathing room to handle liabilities over a longer period, improving its short-term liquidity.
Acid test ratio vs. current ratio: What’s the difference?
Businesses might wonder how the acid test ratio compares to the current ratio. Although both measure liquidity, the difference lies in the types of assets they consider. The current ratio includes all current assets, including inventory and prepaid expenses, which are not part of the acid test ratio.
For this reason, the acid test is a stricter measure, as it focuses on assets that businesses can quickly convert into cash. The current ratio may be more optimistic, while the acid test ratio gives a more conservative view of the company’s short-term financial position.
Wrapping up
The acid test ratio is handy for determining a company’s liquidity. It asks: “Can this business cover its short-term debts with its current cash and liquid assets?” If businesses get a ratio above one, they are in the clear. But if their calculations show a ratio below one, there might be some red flags.
However, even if the acid test ratio isn’t great, businesses can improve it by boosting their cash reserves, speeding up collections, slimming down their inventory, and cutting back on current liabilities. Remember to keep an eye on this ratio, as it gives a solid snapshot of financial health and the ability to handle short-term obligations.
