All companies that wish to be in business for the long haul must form informed financial strategies. If you’ve been in business for any length of time, you know that business data is key in making decisions and determining your company’s overall direction. One figure you need to keep tabs on is the acid-test ratio.
The acid-test ratio is a measure of your company’s liquid assets compared to your debts. Let’s learn why this information is crucial for assessing your company’s health and how it can help you build a viable financial strategy for the future.
What Is the Acid-Test Ratio?
A ratio is simply a comparison between two numbers of the same unit to determine the quantitative relationship between them. In general, accountants and other financial professionals use these numbers as comparison points that allow for a thorough evaluation of a company’s financial health.
For example, financial analysts may compare a company’s past and future performance to see growth or decline year over year or compare the company’s data to one of its competitors. In context with other information from a company’s business intelligence data or financial statements, ratios can give strategic insights into how profitable a company is, whether it’s operating at peak efficiency, and whether it has sufficient liquidity.
The acid-test ratio (or quick ratio) is commonly used to measure liquidity. It specifically tells a company whether it has enough short-term assets to cover all the liabilities it has currently incurred. If it does not, it is often assumed that the company is on shaky financial ground.
In addition to the acid-test ratio, there are two other major liquidity ratios that financial professionals can use to gauge a company’s health:
- The Current Ratio: The measure of whether a company can pay off its total liabilities with its total current assets; unlike the acid-test ratio, this one does not exclude inventory
- The Day Sales Outstanding (DSO) Ratio: A measure of how many days, on average, it takes a company to collect payment after a sale
All of these ratios play a crucial role in both assessing financial health and determining financial strategy, and it’s always worth looking at each ratio in relation to the others to gain full context.
Calculation Demystified: How to Calculate the Acid-Test Ratio
To calculate the acid-test ratio, a company needs access to the following data points, each of which can be found on the company’s balance sheet:
- Marketable securities, financial instruments and investments that can easily be sold for cash (such as stocks, bonds, ETFs, or mutual funds)
- The amount of cash and cash equivalents the company has in its possession, like savings accounts and T-bills
- Accounts receivables, which is money customers currently owe the company for goods and services already provided
- Current liabilities that are due now or will be due within a year
This information is then used in a simple two-step formula:
- Add your cash and cash equivalents, marketable securities, and accounts receivable
- Divide that number by your current liabilities
. If you wish, you can perform an acid-test ratio calculation using an online ratio calculator to simplify the process.
Strategic Implications: Significance of the Acid-Test Ratio in Financial Decision-Making
The basic premise of the acid-test ratio is that at all times, a company should be able to pay its bills without having to sell inventory or borrow money to do so. If it cannot, the company may be paying off debts too quickly, collecting on accounts receivable too slowly, or struggling to increase sales. It may also have too much debt.
When a company has a low acid-test ratio, leaders may want to consider pivoting the business strategy to raise it, by either gaining more quick assets or reducing liabilities. For example, businesses with a low acid-test ratio may want to consider asking shareholders to increase their investment in the company or making a serious push to collect on accounts receivable by incentivizing early payment.
While different ratios are appropriate in various scenarios, there are some situations where the acid-test ratio is more reliable than other liquidity ratios. These include investors analyzing a company’s ability to stay afloat during challenging economic times or businesses that are suddenly facing the threat of bankruptcy or layoffs and need to quickly turn things around.
Comparing Ratios: Acid-Test vs. Current Ratio
Along with the acid-test ratio, the current ratio (or working capital ratio) is another liquidity calculation that analysts use to determine whether a company can pay its bills or not.
While the acid-test ratio takes into account only liquid assets (or those that can be easily liquidated), the current ratio takes all assets into account, including inventory and other current assets (OCA) that can be turned into cash within one year. It is calculated using the following simple formula:
There are scenarios in which it is better to use the acid-test ratio rather than the current ratio. These include situations where a company needs cash to cover liabilities within 90 days, such as in the case of bankruptcy.
If the acid-test ratio falls much lower than the current ratio, it means that the company is mainly relying on inventory to cover current liabilities. While this may not be a bad thing, it is something for business leaders and investors to take note of.
Real-World Application: Acid-Test Ratio Examples
One real-world example of calculating and using the acid-test ratio to make investing and financial decisions can be found in the car sales company Carvana. In late 2022, online-only used car retailer Carvana laid off a significant portion of its staff, leading to fears of bankruptcy among investors. In its second-quarter earnings report, the company indicated it had:
- $541 million in cash and cash equivalents
- $335 million in accounts receivable
- $2.18 billion in current liabilities
Using the traditional formula, the acid-test ratio can be calculated as follows:
- Add short-term assets together: $541M + $335M = $876M
- Divide that number by the current liabilities: $876M / $2.18B = 0.4 Acid Test Ratio
In this particular scenario, the acid-test ratio is quite low. However, the company did report $1.1B in financial receivables (accounts receivable that can quickly be converted to cash via a financing company) and $1.3B in car inventory that has the potential to be sold.
In this case, the acid-test ratio would make it appear that Carvana was in significant trouble. However, the company has a current ratio of 1.79. The acid-test ratio falls well below the current ratio, which means at the time, Carvana was heavily reliant on financing and inventory to pay debts.
Still, while the company didn’t have much liquidity, it was in a greater position to bounce back than the acid-test ratio alone made it appear. In a case that demonstrates the value of looking at more than one ratio, Carvana stock rebounded 40% in mid-2023 after executives made the strategic decision to focus on debt reduction.
Common Pitfalls: Interpreting Acid-Test Ratio Results
The acid-test ratio is a decent measure of a company’s ability to pay its bills. However, there are some important caveats to be aware of when interpreting your ratio results and using the number to make financial decisions.
While the acid-test ratio is a more conservative estimate of financial health, it isn’t the only estimate. As demonstrated in the Carvana example, the level of access to short-term liquid assets doesn’t tell the whole story of a company’s finances. If the quick ratio is very low while the current ratio is high, it may warrant a change in financial strategy, but it doesn’t mean the company is necessarily in as much trouble as it may seem.
Courtesy of WallStreetMojo
Additionally, an extremely high acid-test ratio is not always a good thing. It may indicate that a company has too much cash it isn’t using to grow the business or too much in accounts receivable. Both of these scenarios require a change in financial strategy.
Finally, what is considered a good acid-test ratio depends heavily on your industry and the nature of your business. If the company can quickly convert inventory to cash, then inventory may actually be a short-term asset, even if the quick ratio doesn’t account for it. If you have an established company with a solid credit history that gives you easy access to financing, a low quick ratio may not matter as much.
The Acid-Test Ratio Is a Valuable Tool in Your Financial Decision-Making
The acid-test ratio is a comparison of your company’s short-term liquid assets to its current liabilities. In conjunction with other data points, knowing this number can help you manage your finances so that you have enough to pay your immediate debts at all times. With this information in hand, you’re much better equipped to create an effective financial and operational strategy for your business.
It’s important to realize that the acid-test ratio will never tell you everything you need to know about your company’s financial health. Still, it is undoubtedly a valuable tool that you should be using in your financial decision-making.
