Acid Test Ratio is not only a financial term, but it gives you clear insights about a company’s financial stability or performance in short term. It acts a tool to gauge company’s financial performance. Acid Test Ratio is also known as ” quick ratio” .
What is Acid Test Ratio ?
Let us imagine that you are running a business and you have bills to pay in short term. Acid test ratio is nothing but ” your ability to pay all the short term bills of the company immediately without depending on selling on inventory and future sales”. You have to pay the immediately bills just by making use of the assets like cash and money you owe from customers. Anyway let us make it more easy for you to understand.
The acid test ratio is a financial indicator that provides you with an understanding of how well your company is able to meet its immediate obligations by utilizing just the assets that can be converted into cash in a short amount of time. Assets like inventory or real estate etc. takes time to convert into cash, so we won’t count them as assets for paying short term bills [ at least in this case ].
In case of Acid Test Ratio, we should consider assets like cash that is readily available in the bank, amounts receivable from customers and investments that are easy to cashed out quickly like stocks, mutual funds and bonds.
For more clarity on “What exactly is Acid Test ratio is ? ” we will explain the term with an example.
Lets suppose, Company “A” has to pay bills of $ 20000 in short term / immediately. You can consider this as current liabilities. Similarly company “A” as cash of $20000 in bank account and $ 10000 to come from customers and $ 10000 of investment in bonds. These $20000 + $10000+$10000 can be considered as assets that are easy to cash out.
Formula of Acid Test Ratio :
Acid Test Ratio=Current Liabilities (Bills and Debts Due Soon) / Quick Assets (Cash, Receivables, Investments)
$40000/$20000 = 2
In this case Acid test Ratio is 2.
This indicates that you have $2 in money that are quickly available for every $1 that you owe on short-term debt. General thumb rule is, if the Acid test ratio is one or above, it is generally considered to be a positive indicator because it indicates that you are in a strong position to meet your immediate financial obligations.
Acid test ratio is calculated by applying a straightforward formula that assesses a company’s capacity to meet its short-term obligations with the assets that are the most liquid.
Quick Assets: Assets that can be converted into cash in a short amount of time with ease and without any impact on their worth.
Current liabilities: Another simple fin term that explains financial commitments that a company is required to pay within the next year / next few months . Examples of current liabilities are short-term loans, and other immediate debts.
Why the Ratio is coined as “Acid Test Ratio “?
Long back, Miners would use acid to determine whether the shiny piece of metal was actually gold or not. This is where the name “acid test” originated. If the shiny piece of metal is gold then it would sustain the test without getting harmed by the acid. If the shiny piece of metal is not gold then it would not pass the test.
Similar to the acid test ratio in finding the genuine gold , this acid test ratio is a rigorous and straightforward method of evaluating the financial health of a company.
It eliminates assets that are less liquid and assets which takes time to convert in immediate cash like inventory etc. Instead this Ratio focuses on assets that can be utilized immediately to meet pressing financial necessities.
So Acid Test Ratio has become an essential instrument for determining whether a company is able to withstand the pressures of the financial market or not without relying on assets which are not easy to liquidate.
Importance of Acid Test Ratio in Financial Analysis :
As we have earlier stated acid test ratio is not merely a numerical value. It acts a vital indicator in analyzing the short-term financial health of a company.
A Gauge to measure Financial Preparedness in case of unexpected events :
Any individuals life is full of surprises, similarly a Company’s financial health can be. There are few unexpected events which may temporarily hinder company’s financial performance. Once recent example about unexpected event is ” Corona Pandemic”. Companies related to Pharma and Medical has performed exceptionally during the pandemic, but companies related to entertainment like Theatres didn’t perform well during this tough phase.
Suppose the Company “B” is into entertainment industry and it has to pay bills in short term [ during corona pandemic ] .
Acid test ratio is a useful tool for determining whether a company is able to deal with unforeseen events, such as an unexpected expense or a rapid decline in revenue, without having to scramble for additional funds or take out emergency loans.
For Investors & Creditors :
Gaining the confidence of both Investors & Creditors is very crucial in successfully establishing and running a business.
Investors prefer to invest their money into companies that are able to withstand any unexpected events. Investors will feel more comfortable investing in a company with healthy acid test ratio because it demonstrates that your business is financially solid and able to deal with issues in the short term.
When you are looking for a loan or credit, you will for lenders. But Lenders before giving you the required credit they look at the Acid Test ratio to determine whether you will be able to repay on time or not . A high acid test ratio can provide you with an advantage when it comes to negotiating terms in your favor.
Comparing with Other companies in the Same Field :
Acid test ratio enables you to evaluate your company in comparison with others in the same industry.
If your ratio of your company is significantly lower than the average for the industry, it is a red flag and indicates that you are in difficulty. Similarly if your company has greater ratio then it is a positive sign indicating that you are ahead of the peers.
You can see Acid Test ratio as an Early Warning :
When the acid test ratio is low, it indicates that there is a possibility of trouble. These early signs alerts you and you can take appropriate measures to improve the overall financial health of the company.
Leave a Reply