The acid-test ratio, also known as the quick ratio, is a financial metric used to evaluate a company’s short-term liquidity position. It measures the ability of a company to pay off its current liabilities without relying on the sale of its inventory. The formula for the acid-test ratio is (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities.
Think of the acid-test ratio as checking how quickly a company can pay its immediate bills without selling off its stock of goods. It’s like looking into your wallet and bank account to see if you can pay your bills without having to sell something you own. A higher ratio means a company is in a better position to cover its short-term debts, which is good for its financial health.
The acid-test ratio is widely used in the fields of financial analysis and accounting. Investors, creditors, and management use it to assess a company’s financial robustness and its risk of facing liquidity issues. This ratio is particularly important in evaluating companies in sectors where inventory cannot quickly be converted into cash.
For Example, A company with Rs. 150,000 in cash and cash equivalents, Rs. 100,000 in marketable securities, Rs. 50,000 in accounts receivable, and Rs. 200,000 in current liabilities would have an acid-test ratio of 1.5. This means it has Rs. 1.5 available to cover each Rs. 1 of its short-term liabilities. If a company’s acid-test ratio is less than 1, it might struggle to pay off its short-term debts without selling inventory. A ratio greater than 1 suggests it can meet its short-term obligations more comfortably.
Source: A to Z of Economics by Dr. NC Raghavi Chakravarthy