The
acid test ratio (or quick ratio) is a
measurement of a company's ability to
pay short term liabilities without selling
inventory.
The
acid test ratio does not contain any inventory
yet accounts receivable are included.
The downside is that there is no indication
of how easily the receivables can be converted
into cash.
The
acid test ratio can be calculated as follows:
Acid test ratio = (Accounts receivable
+ Cash equivalents + Cash) / Current liabilities
When
using any liquidity ratio, generally accepted
acid-test ratio values will vary by industry
and should only be compared to other companies
in the same industry.
Generally,
a value of at least 1 is required, and
the higher the number, the better. (A
ratio of less than one means the company
cannot meet it's current liabilities and
a value of 2 would mean the company could
cover the liabilities twice.) Generally,
higher numbers are a favorable indicator
of the ability to pay short-term debts
and very high ratio values can indicate
poor receivables or excess cash reserves.
- Lower
values show that the company may experience
problems paying short-term debts.
Companies with lower values should
consider liquidating some inventory,
refinancing short-term debt with long-term
debt and/or consider a sale/leaseback
of fixed assets.
- Extremely
high ratio's can indicate unnecessary
accumulation of funds (too much inventory)
or bad financial management.
Out
of the three main liquidity ratio's, typically
the current ratio will tend to overstate
the short term liquidity and the cash
ratio will tend to understate the short
term liquidity and somewhere in the middle
is the acid test/quick ratio.
Note:
Ratios should not be used as the only
valuation method since ratios are only
as reliable as the data on which they
are based. Ratio's should therefore be
supplemented with other complementary
methods to achieve a reasonable opinion.
Also
see:
United States
Canada
