Banking Financial Analysis Investment

Acid Test Ratio or Quick Ratio

What is Acid Test Ratio or Quick Ratio?

Definition of Acid Test Ratio or Quick Ratio: The most basic definition of the acid-test ratio is that “it is a measurement of current (short term) liquidity and position of the firm”.

The acid test or quick ratio is an astringent and meticulous measurement of the ability of the company. The company is to pay its current obligation as and when they are due.

It assesses whether a business has sufficient assets to pay its short-term liabilities by converting it into cash. The quick ratio helps to assess liquid assets and current liabilities of the firm.

The ideal quick ratio is 1: 1 and regarded as acceptable. The financial analyst analyses the availability of the current assets of the firm. Measure it against the current liabilities to induce the position of the firm to pay off capability.

High Acid Test Ratio is a perfect signal. It shows the firm is a relatively better financial position and adequacy to pay off its current obligation in time.

Cash, marketable securities, and accounts receivable or sundry debtors excluding Inventory is the key figures of current assets. It determines the quick ratio or acid test ratio.

Quick liabilities include all current liabilities excluding Bank overdraft. It is secured by the inventories, the other current assets must be sufficient to meet other current liabilities.

Due to the exclusion of inventory from this ratio, it’s a better sign than the current ratio to evaluate the power of an organization to pay its instant obligations.

That’s why known as acid test ratio or liquid ratio.

Short-term investments or marketable securities embrace trading securities and readily available for sale securities that may easily be converted into liquid cash within the next 90 days.

Marketable securities are traded on an open market with an identified price and readily available buyers.

Importance and Advantages of Quick Ratio:

  • This shows the ready cash position of a firm.
  • This removes the errors of the current ratio.
  • This ratio is supplementary to the current ratio.
  • The quick ratio excludes the closing stock at the time of computation.
  • More worthy in ensuring the liquidity position of the company than the current ratio.
  • More authentic repayment capacity of the organization as calculated for current ratio including closing stock.
  • It excludes the inventory while calculation which was included in the current ratio.
  • It may be overstated where large inventory base, that situation can be tackled and will limit companies getting an additional loan

The disadvantage

  • This ratio may not be sufficient to analyze the liquidity position of the firm alone, the means for calculation of this ratio may possible with other ratios to get effective results.
  • It removes inventory from the calculation, which may not be appropriate for businesses where large inventory can be appreciated at a marketable price easily.
  • This ratio may not be a good sign for all business models for showing short term solvency.
  • Because if companies with usually higher inventory, like supermarkets exclude inventory to arrive at liquidity positions, it may not be essentially correct to do so.
  • Ignores the level and the timing of the cash flows which actually would be a major parameter determining the company’s ability to pay liabilities when they become due.
  • The ratio considers accounts receivables as liquid and can be easily converted to cash which may not always be the case.

The formula

Quick ratio Formula = Quick assets / Quick Liabilities = (Cash and Cash Equivalents + Accounts receivables + Short term Investments) / (Current liabilities – Bank overdraft)

OR

Quick ratio Formula = (Total Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

Example

Let’s suppose that XYZ Company is applying for a loan to remodel the storefront of the shop. The bank asks XYZ for a detailed balance sheet, so it can compute the quick ratio. XYZ’s balance sheet included the following accounts:

  • Cash: $12,000
  • Accounts Receivable: $5,000
  • Inventory: $2,000
  • Stock Investments: $1,000
  • Prepaid taxes: $500
  • Current Liabilities: $15,000

The bank can compute XYZ’s quick ratio like this.

Total Current Assets = Cash + A/c Receivable + Stock Investments

= $12,000 + $5,000 + $1,000

=$18000

Quick ratio Formula = (Total Current Assets – Inventory – Prepaid Expenses) / Current Liabilities

= ($18000 – $2000 – $500) / $15000

= $15500 / $15000

=1.03

As we can see XYZ’s quick ratio is 1.03. This means that XYZ can pay off all of its current liabilities with quick assets and still have some quick assets left over.

Interpretation and Analysis of Acid Test Ratio or Quick Ratio

An acid test ratio is a tool of measurement of the liquidity condition of a firm by its ability to pay off its current liabilities with the help of quick assets.

If a firm has enough liquid assets to meet up its total current liabilities, the firm will be capable to pay off its obligations without selling off any long-term asset or Capital.

For the most part of businesses use their long-term assets to generate revenues by selling off their capital resources will not only hurt the company.

It does also indicate the investors that current operations aren’t making enough profits to pay off current liabilities.

The ideal and appropriate Quick Ratio is 1: 1 for a company. The financial analyst analyses the availability of the current assets of the company against the current liabilities to get the position of the company to pay off capacity.

High Acid Test Ratio is a perfect signal that shows the firm is a relatively better financial position and adequacy to pay off its current obligation in time.

Cash, marketable securities, and accounts receivable or sundry debtors excluding Inventory is the key figures of current assets to determines the quick ratio or acid test ratio.

Quick liabilities include all current liabilities excluding Bank overdraft because bank overdraft is secured by the inventories, the other current assets must be sufficient to meet other current liabilities.

Due to the exclusion of inventory from this ratio, it is a better sign than the current ratio to judge the ability of a company to pay its instant obligations that is why also known as Acid test ratio or liquid ratio.

Short-term investments or marketable securities consist of trading securities and presented for sale securities. It may easily be converted into cash within the next 90 days.

Marketable securities are traded on working hours of the market with a known price and readily available buyers.

Obviously, as the ratio increases so do the liquidity of the company increases. If the company wants more assets can be easily changed into a liquid asset if needed.

This is a good indication for investors as well as an even better sign to creditors because creditors want to recognize they will be paid back on time.

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