As an investor, you would want to know various crucial aspects related to a company’s true worth -
● How much do you know about the company’s products and services?
● How much should you expect as returns for your investment?
● Where does a company lie on the graph of assets-vs-liabilities?
This is where the acid test ratio, also known as the quick ratio, comes into the picture as an important financial measure. It encompasses a company’s financial health in relation to its short-term assets and liabilities. Ideally, you, as an investor, would want to invest in companies with better financial health. Checking this ratio can take you closer to making the right investment decision.
Wondering what more lies in the acid test ratio meaning? Let’s dive deeper.
What is the Acid Test Ratio?
In financial terms, the acid test ratio measures a company’s liquidity and determines how well its current assets can cover its current liabilities.
Here, current liabilities refer to the debt payable within one year. Also, you should know that the companies disregard various existing assets that are difficult to liquidate while calculating the acid test ratio.
Acid Test Ratio Formula
Given below is the formula for calculating the acid test ratio:
Acid Test Ratio = (Sum of cash and cash equivalents, accounts receivables, and marketable securities) / Current liabilities
Here,
● Cash and cash equivalents are the liquid current assets of a company you want to invest in.
● Marketable securities are the ones that can be easily converted into cash.
● Accounts receivables cover the money owed to the company for selling goods and/or services.
How Should You Interpret the Acid Test Ratio?
As depicted in the formula, the higher the numerator above, the better the coverage for a company’s liabilities. Ideally, a company should have or maintain an acid test ratio of 1 or higher, which means that it has liquid assets to cover its short-term debt obligations.
● An acid test ratio lesser than one means the company does not have sufficient current assets to cater to its short-term liabilities.
● On the other hand, a very high ratio indicates that it has accumulated enough cash that is not reinvested into productive functions.
Is Acid Test Ratio Enough to Determine Your Investment Decisions?
As with any other financial metric, the acid test ratio also has certain limitations and drawbacks. You should also know that:
● This ratio alone is not sufficient to determine a company’s liquidity. You would need other parameters, such as the cash flow ratio or current ratio, to get a more accurate estimate of the company’s liquidity.
● Since inventory is not considered liquid assets, it is excluded from the acid test ratio calculation. However, for businesses that can quickly sell their inventory at a fair price, their inventory qualifies as an asset converted to cash readily.
● The ratio does not provide information related to the level and timing of the cash flows, which are important to determine a company’s ability to clear the dues.
● While calculating this ratio, it is assumed that the accounts receivables are readily available for collection, which is not always the case.
Additional Read: What is ESG?
FAQs
How is the Acid Test Ratio Different from the Current Ratio?
The acid test ratio formula considers only the most liquid current assets. On the other hand, the current ratio covers total current assets, many of which may be less liquid.
How is Liquidity Different From Solvency?
Liquidity implies a company’s ability to fulfil its short-term obligations and can be gauged using the acid test ratio or current ratio. Solvency refers to a company’s state in which it can meet its long-term debts and similar other obligations.
At last, it is your understanding of various financial terms like acid test ratio that helps in selecting the right companies for investments.
Additional Read: What is PB Ratio?
Disclaimer:
The information herein is meant only for general reading purposes, and the views being expressed only constitute opinions and, therefore, cannot be considered as guidelines, recommendations or a professional guide for the readers. The document has been prepared based on publicly available information, internally developed data and other sources believed to be reliable. The sponsor, the Investment Manager, the Trustee or any of their directors, employees, associates or representatives (“entities & their associates”) do not assume any responsibility for, or warrant the accuracy, completeness, adequacy and reliability of such information. Recipients of this information are advised to rely on their own analysis, interpretations & investigations. Readers are also advised to seek independent professional advice in order to arrive at an informed investment decision. Entities & their affiliates including persons involved in the preparation or issuance of this material shall not be liable in any way for any direct, indirect, special, incidental, consequential, punitive or exemplary damages, including on account of lost profits arising from the information contained in this material. Recipient alone shall be fully responsible for any decision taken on the basis of this document.
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