Understanding the acid test ratio (quick ratio)
One of the biggest challenges that any growing business faces is cash flow and ensuring there’s enough money to meet upcoming financial obligations such as wages and supplier payments. The acid test ratio, sometimes called the quick ratio, is a financial analysis metric that can help business owners understand how well their company can meet its short-term financial obligations.
Moreover, the acid test ratio is also widely used by lenders and banks to make decisions about lending and access to credit.
How to use the acid test ratio
The acid test ratio essentially measures the relationship between a company’s immediate access to cash and its immediate liabilities, helping to assess immediate financial health. It's a useful metric because it focuses on a company's most liquid assets, offering a conservative view of its capacity to meet short-term obligations.
“If you had to settle your immediate liabilities, the acid test ratio says how easily you could access the liquid resource to do so,” explains Mahmood Reza, Founder of the I Hate Numbers accounting company. “From a business point of view, if you can’t pay your suppliers, you might need to borrow cash or sell assets to improve working capital and keep the business flowing.”
The acid test ratio formula
The acid test ratio, or quick ratio, is expressed as a whole number. It can be calculated using this formula:
Acid Test Ratio (Quick Ratio) = Current assets – Inventory / Current Liabilities
The acid test ratio excludes inventory because this is not necessarily an asset that can be immediately converted to cash. Only cash and liquid assets are included and then divided by total short-term liabilities.
If the outcome of the equation is less than 1, then the acid test ratio shows that the company does not have enough immediate access to liquid funding to settle its immediate financial liabilities.
If the company has a quick ratio that is higher than 1, then the company could settle its immediate liabilities from liquid assets within the business.
Acid test ratio example
Company A creates air conditioning systems. The company has inventory valued at £100,000, along with £200,000 in cash and a further £40,000 in accounts receivable. The company’s total assets are £340,000, but £100,000 is in inventory and thus excluded from the acid test ratio calculation.
The business owes £50,000 in accounts payable, and £10,000 in short-term debt, meaning the company’s total liabilities are £60,000.
Acid Test Ratio (Quick Ratio) = £340,000 – £100,000 / £60,000
Using the acid test ratio or, quick ratio formula, shows that Company A has a quick ratio of 4:1, meaning that it has enough liquidity to pay its short-term liabilities four times over.
Advantages and disadvantages of the acid test ratio
Simplicity
The key advantage of the acid test ratio is that it is a relatively accessible and understandable view of a company's current financial position.
“If you come into the office, open up your accounting system and want to compare what’s in the bank with what you owe to suppliers, then acid test ratio is a useful calculation to understand your position,” says Reza.
If your company has £10,000 in bills, but you can see that your customers owe you £20,000 then that’s useful information, Reza adds. But if you can see that you have £10,000 in bills and your customers haven’t yet been invoiced, then the acid test ratio is a heads-up to take action: “Your acid test ratio might alert you that you need to adjust your customers’ payment terms and work to 14 rather than 30-day terms, or you need an overdraft for the short-term,” says Reza.
Access to finance
Maintaining a healthy acid test ratio can help your business access finance more easily, says Reza. Companies that have a high acid test ratio will generally find it easier to access loans, overdrafts and credit cards, that can be used to help your business to grow. “Lenders often use the acid test ratio to understand the level of risk associated with providing finance to a business. If you have a lower ratio, then you might find credit is harder to find or more expensive,” he says.
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Requires up-to-date information
“The acid test ratio is only useful if financial records are up-to-date,” says Reza. “If an organisation has invested in digital infrastructure and the accounts are maintained, then it’s a useful ratio, but if you don’t know how much you owe your suppliers at any point in time, then the calculation becomes meaningless,” he says.
Limited detail
The acid test ratio only provides an overview of liquidity and may, in some circumstances, be misleading. For example, if a business has lots of liabilities that fall due within 60 days but accounts receivables that might not be paid for 120 days, then the company could have a healthy acid test ratio – but be in trouble.
Acid test ratio (quick ratio) vs current ratio
The acid test ratio formula is very useful for understanding how well a business can meet short-term liabilities, and is very similar to the current ratio. However, the key difference is that the current ratio also includes inventory and longer-term accounts receivable, which may not be immediately available to liquidate.
The current ratio includes inventory and things like raw materials or work in progress, explains Reza. This means that the current ratio for a healthy company will likely be higher than its acid test ratio. “The old-fashioned wisdom is that a 2:1 ratio meant you’re reasonably liquid, but there’s a higher level of risk because some of your assets are tied up in inventory that you might not be able to sell if your inventory went bad or the marked changed,” he says.
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