Finance

Acid-Test Ratio

Acid-Test Ratio

A ratio is the proportion of two elements that gives information on a particular detail related to the element consider in the calculation. An Acid Test Ratio is a type of ratio used to know the financial condition of any company, firm, organization, or any small shop or business unit. Under the acid test ratio, liquid current assets, and current liability of the company is considered. This ratio helps to understand how much a company is capable to pay its short-term obligations or liability. Because of this characteristic, this ratio is also known as Quick Ratio or Absolute Cash Ratio and it also comes under the head of the liquidity ratio.

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Acid Test Ratio is an advanced version of the Current Ratio. Current Ratio = Current Asset/Current Liability and under Current Assets, debentures, bills receivables, cash, bank balance, prepaid expenses, and stock are considered. With the help of the Acid Test Ratio, it is easier to know which liquid assets are available which the company and whether the company able to meet its short-term liability or not. The minimum acid-test ratio that the company should maintain is 1. If the Acid Test Ratio is less than 1, it means that the particular company is not able to meet its obligation and if the ratio is greater than 1 which means the company is in a position to meet its short-term obligation of liability.

The formula of Acid Test Ratio:

Acid Test Ratio = Liquid Current Assets/Current Liability

Liquid current assets include cash and cash equivalents, marketable security, and accounts receivables.

Current Liability includes all short term debt obligations like a bank overdraft, bills payable, provisions, outstanding expenses.

  • Cash and Cash Equivalents include the cash available in the company’s balance sheet or can be converted into cash immediately.
  • Marketable Security includes all types of short-term investments made by the company by which they will earn a return within a year like bank deposits, bonds, etc.
  • Accounts Receivables are the amount which the company will get from their customers and other parties.
  • Bank Overdraft is the amount of money that a company has used from the bank even if there were no funds in the company’s account.
  • Bills Payables are the obligation that companies have to pay to another party.
  • Provisions are made by the company to cover their future risk. Various provisions are made to cover the short term risk are considered under this ratio.
  • Outstanding Expenses are the amount that a company has to pay to meet their day to day expenses.

Let’s say for example,

A company is having 1, 50,000 of liquid current assets, and 2, 00,000 of current liability, and its acid-test ratio will be as follows:

Acid Test Ratio = Liquid Current Assets/ Current Liability

Acid Test Ratio = 1, 50,000/2, 00,000

Acid Test Ratio = 0.75

As the acid test ratio is less than 1, we can say that the company here is not in a position to meet its short-term liability.

Now if the company is having 2, 50,000 liquid assets and 2, 00,000 of current liability then its acid-test ratio will be as follow

Acid Test Ratio = Liquid Current Assets/ Current Liability

Acid Test Ratio = 2, 50,000/2, 00,000

Acid Test Ratio = 1.25

Here, the ratio is greater than 1 so we can say that the company is in a position to meet its short-term liability.

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Advantages of Acid Test Ratio:

  • One of the biggest advantages of this ratio is that it does not take inventory into consideration and because of that, the real scenario of the company comes into account, that how much a particular company is able to meet its debt obligation with the help of liquid assets.
  • As the name suggests Quick Ratio, quickly gives the result that a company is financially strong or not to cover their debt obligation by its standers ratio. If the ratio is less than 1 then the liquid assets are less than compared to current liability and if the ratio is more than 1, this means that liquid assets are more than a current liability.
  • Acid Test Ratio is one of the simplest and easiest ratios to know the liquidity of the company.
  • It covers comes the limitation of the current ratio by removing inventory and pre-paid expenses to know the accurate liquidity of the company.

Disadvantages of Acid Test Ratio:

  • Only the Acid Test Ratio alone cannot shows the profitability of the company various other ratio is also taken into consideration to know the accurate profitability of the company.
  • As this ratio removes inventory from the calculation, then with the help of this ratio we cannot find the accurate financial position of the firm who are engaged in high inventory maintenance.
  • It takes time to convert the liquid assets into cash and this timing of the cash flow in the company is totally ignored by the ratio.
  • This ratio is not suitable for all types of business, thus to know the accurate liquidity of the company on the basis of the acid test ratio, some criteria should be taken into consideration.

 Conclusion:

Acid Test Ratio is a quick and easy way to know any company’s financial position but along with that, one should take into understanding what type of company analysis one is trying to conduct. It also helps the general public to know the outer scenario of the company with this basic calculation. Thus, along with its limitation, this ratio is very useful under certain conditions to make decisions about the company.

 

Author: Charmi Mehta

About the Author: Charmi Mehta is currently pursuing an MBA with a specialization in Finance from the Department of Business Administration, Bhavnagar. Charmi is very much interested to work with data and its analysis and she is also fascinated by the financial market.

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